30 ATaleofTwoMarkets
the stock’sβ(beta). Under CAPM, stocks with higherβ’s are more
risky than are stocks with lowerβ’s because they tend to swing more
widely than does the market—their returns exhibit greater dispersion
versus market returns.
Critique and Common Sense
On their own terms, there are several weaknesses in MPT and
CAPM. First, in evaluating EMT, the need for a pricing model cre-
ates a joint hypothesis problem: No one can ever be sure in testing
a model whether its failure is due to market inefficiency or to an
inadequately specified asset pricing model.
Indeed, many of the anomalies in EMT mentioned earlier are
attributed to deficiencies in the asset pricing model rather than to
the presence of market inefficiency. These deficiencies are most of-
ten associated with imprecision in defining ris kor, equivalently, in
specifyingβ.
The joint hypothesis problem has an important implication for
EMT skeptics. To disprove EMT requires proof that does not use an
asset pricing model. However, any linear or nonlinear dependence
in stoc kprice behavior is inconsistent with EMT itself. Thus, a dis-
covery of linear or nonlinear dependence in successive stoc kprices
(presented in the next chapter) means EMT is incomplete, period.
It does not admit the alternative explanation of a “misspecified” asset
pricing model.
In addition, CAPM says that expected returns from an invest-
ment are linearly related to expected returns on the portfolio of
which that investment is a part. The linear relationship is given by
βand is in turn dictated by CAPM’s rational-expectations assump-
tion.
If human behavior is itself inconsistent with the rational-
expectations assumption, there is no reason to believe in such a
linear relationship. This is another way of saying that the stoc kmar-
ket is nonlinear rather than linear. In that case,βwill not be an
accurate measure of risk.
Finally, the rational-expectations assumption used in the CAPM
requires that investors have homogeneous return expectations; this
in turn requires that investors evaluate and understand information
in identical ways. Heroic as that sounds, it would also require all
investors to evaluate investment opportunities over identical time