Some Concerns about Beta and the CAPM
The Capital Asset Pricing Model (CAPM) is more than just an abstract theory described in
textbooks—it is also widely used by analysts, investors, and corporations. However, despite
the CAPM’s intuitive appeal, a number of studies have raised concerns about its validity. In
particular, a study by Eugene Fama of the University of Chicago and Kenneth French of
Yale cast doubt on the CAPM.^17 Fama and French found two variables that are consistently
related to stock returns: (1) the firm’s size and (2) its market/book ratio. After adjusting for
other factors, they found that smaller firms have provided relatively high returns, and that
returns are relatively high on stocks with low market/book ratios. At the same time, and
contrary to the CAPM, they found no relationship between a stock’s beta and its return.
As an alternative to the traditional CAPM, researchers and practitioners have be-
gun to look to more general multi-beta models that expand on the CAPM and address
its shortcomings. The multi-beta model is an attractive generalization of the tradi-
tional CAPM model’s insight that market risk, or the risk that cannot be diversified
away underlies the pricing of assets. In the multi-beta model, market risk is measured
relative to a set of risk factors that determine the behavior of asset returns, whereas the
CAPM gauges risk only relative to the market return. It is important to note that the
risk factors in the multi-beta model are all nondiversifiable sources of risk. Empirical
research investigating the relationship between economic risk factors and security re-
turns is ongoing, but it has discovered several risk factors, including the bond default
premium, the bond term structure premium, and inflation, that affect most securities.
Practitioners and academicians have long recognized the limitations of the CAPM,
and they are constantly looking for ways to improve it. The multi-beta model is a po-
tential step in that direction.Are there any reasons to question the validity of the CAPM?
Explain.Volatility versus Risk
Before closing this chapter, we should note that volatility does not necessarily imply
risk. For example, suppose a company’s sales and earnings fluctuate widely from
month to month, from year to year, or in some other manner. Does this imply that the
company is risky in either the stand-alone or portfolio sense? If the earnings follow
seasonal or cyclical patterns, as for an ice cream distributor or a steel company, they
can be predicted, hence volatility would not signify much in the way of risk. If the ice
cream company’s earnings dropped about as much as they normally did in the winter,
this would not concern investors, so the company’s stock price would not be affected.
Similarly, if the steel company’s earnings fell during a recession, this would not be a
surprise, so the company’s stock price would not fall nearly as much as its earnings.
Therefore, earnings volatility does not necessarily imply investment risk.
Now consider some other company, say, Wal-Mart. In 1995 Wal-Mart’s earnings
declined for the first time in its history. That decline worried investors—they were con-
cerned that Wal-Mart’s era of rapid growth had ended. The result was that Wal-Mart’s
stock price declined more than its earnings. Again, we conclude that while a downturn
in earnings does not necessarily imply risk, it could, depending on conditions.138 CHAPTER 3 Risk and Return(^17) See Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of
Finance,Vol. 47, 1992, 427–465; and Eugene F. Fama and Kenneth R. French, “Common Risk Factors in
the Returns on Stocks and Bonds,” Journal of Financial Economics,Vol. 33, 1993, 3–56.