The CAPM establishes a logical relationship between expected rate of returns and portfolio volatility. The greater the latter, the greater should be the mathematical expectancy of high returns. The CAPM shows that the expected returns for a portfolio should exceed that of a risk-free investment; this may be attributed to a risk premium whose amount is proportional to the beta coefficient.
However, empirical studies do not exactly confirm this theory. In a study dating from 1992, two American researchers, Fama and French, considered the monthly returns of stocks quoted in New York from 1963 through 1990.30 These stocks were distributed into 10 portfolios in accordance with their beta coefficients. The first contained those stocks whose beta was weakest; its volatility was assessed at 0.8. The volatility of the second portfolio was assessed at 0.9 and so on. The last portfolio’s volatility was rated at 1.7. Returns should have grown at the same rate as the relative degrees of volatility. Nothing of the sort took place; no correlation emerged. In a more recent study (June 1999) another researcher, John Cochrane, demonstrated that even though a correlation does in fact exist, ‘‘small cap’’ shares provide returns that are higher than their volatility would convincingly lead us to believe.
The trouble with these theories is that statistical tests on returns obtained after the fact fail to render them perfectly justifiable. Practice shows that professional investors base their choices first on historically attested volatility and second on expectations of returns. Portfolio theory is regularly applied. That said, investors often anticipate in an erroneous manner. If they expect prices to rise and choose volatile portfolios in order to make profits, a market downturn will aggravate the effects of disappointing results. It is not because the expected return on a portfolio is 15 percent that it will supply such sizable returns. Risk justifies the fact that an investor demands higher returns than is the case with risk-free rates, and quite rightly so. The CAPM shows us that the more risks are incurred, the higher the returns an investor must demand. However, this is not tantamount to asserting that the higher the risk, the more favorable the returns obtained! Were this the case, it would behove us to take a maximum number of risks, to run up debts and to invest borrowed money in a market portfolio clearly reflecting systemic risk. In the long run, each and every gambler would make a fortune! One would be better off going for broke and putting borrowed money into play on the roulette wheel or on horse races. Were rewards proportional to the risks incurred, gambling would invariably be the best bet. Statistical tests apply to history-based returns or volatility; as for the model, it functions with expectations of returns rather than time-based averages and with estimates of responsiveness instead of past volatility. Expectations of returns may indeed prove to be proportional to the risk incurred, and yet obtained returns may turn out to be disappointing.
Another criticism is that such tests ought not be restricted to stock market securities. When calculating the beta coefficient, the reference market needs to include all the financial instruments and all assets in which the fortune of the world may be invested: unquoted equities, real estate, raw materials, precious metals, the art market and so on. That said, such criticism is basically technical.
More criticism should rather be addressed to the hypotheses that underpin the CAPM. As we saw above, this reasoning is predicated on a strong hypothesis according to which everyone has the same vision of the future. All investors are said to form identical anticipations; as a result, there supposedly exists but only one envelope of efficient portfolios. This assumption is also part and parcel of a well-known economic framework in which markets are always in equilibrium. This basis for CAPM does not hold water. Markets are never well-balanced; any equilibrium is always shifting. Equilibrium between supply and demand is achieved through prices; continual changes in the latter reflect a perpetual displacement of the point of equilibrium.
The second basis for the CAPM logic consists in the would-be existence of a single efficient envelope of portfolios, the set of all the superior portfolios possible in Markowitz’s framework. Yet in order for this envelope to be unique, it would be necessary for all investors to hold the same predictions. However, if everybody shared the selfsame vision of the future, there would be neither buyers nor sellers! In reality, when we talk about markets we evoke transactions; any transaction features the divergent viewpoints of the buyer and the seller. So there can be no single efficient envelope of portfolios. In practice, many investors believe that their idea of the future is more prescient than that of their neighbors. They do not invest in the same portfolio as the rest of the market. Moreover, when there are several points of view, there also exist several portfolio envelopes. One may even wonder whether the number of efficient envelopes is not equivalent to the number of investors, in so far as each of the latter foresees the future differently. If this is the case, one must admit that portfolio structures may differ greatly among particular investors, which does not necessarily call into question the analytical frame of reference. We must not forget that investors have differing horizons; while some of these are short term, others are long term.
Predictions for the future are relevant to a given horizon of investment. When you think of investing over two to three years, you formulate hypotheses on that time span. But if you are a long-term investor (+ 8 years), you tend to rely on trend analysis. When there are sellers and buyers, there also exist several points of view. And if there is a market, sellers and buyers do exist. The market arbitrates their differences. There is no such thing as a consensus about the future. At any given point in time, one may find many efficient envelopes of possible portfolios.