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Chapter 8 Portfolio Theory and the Capital Asset Pricing Model 203Second, investors do appear to be concerned principally with those risks that they cannot
eliminate by diversification. If this were not so, we should find that stock prices increase when-
ever two companies merge to spread their risks. And we should find that investment companies
which invest in the shares of other firms are more highly valued than the shares they hold. But
we do not observe either phenomenon. Mergers undertaken just to spread risk do not increase
stock prices, and investment companies are no more highly valued than the stocks they hold.
The capital asset pricing model captures these ideas in a simple way. That is why financial
managers find it a convenient tool for coming to grips with the slippery notion of risk and why
nearly three-quarters of them use it to estimate the cost of capital.^12 It is also why economists
often use the capital asset pricing model to demonstrate important ideas in finance even when
there are other ways to prove these ideas. But that does not mean that the capital asset pricing
model is ultimate truth. We will see later that it has several unsatisfactory features, and we
will look at some alternative theories. Nobody knows whether one of these alternative theo-
ries is eventually going to come out on top or whether there are other, better models of risk
and return that have not yet seen the light of day.Tests of the Capital Asset Pricing Model
Imagine that in 1931 ten investors gathered together in a Wall Street bar and agreed to estab-
lish investment trust funds for their children. Each investor decided to follow a different strat-
egy. Investor 1 opted to buy the 10% of the New York Stock Exchange stocks with the lowest
estimated betas; investor 2 chose the 10% with the next-lowest betas; and so on, up to investor
10, who proposed to buy the stocks with the highest betas. They also planned that at the end
of each year they would reestimate the betas of all NYSE stocks and reconstitute their portfo-
lios.^13 And so they parted with much cordiality and good wishes.
In time the 10 investors all passed away, but their children agreed to meet in early 2015 in the
same bar to compare the performance of their portfolios. Figure 8.8 shows how they had fared.
Investor 1’s portfolio turned out to be much less risky than the market; its beta was only .48.
However, investor 1 also realized the lowest return, 8.2% above the risk-free rate of interest.BEYOND THE PAGEmhhe.com/brealey12eFigure 8.8:
Returns and beta◗ FIGURE 8.8
The capital asset pricing model states
that the expected risk premium from any
investment should lie on the security mar-
ket line. The dots show the actual average
risk premiums from portfolios with different
betas. The high-beta portfolios generated
higher average returns, just as predicted
by the CAPM. But the high-beta portfolios
plotted below the market line, and the low-
beta portfolios plotted above. A line fitted
to the 10 portfolio returns would be “flat-
ter” than the market line.
Source: F. Black, “Beta and Return,” Journal of Portfolio
Management 20 (Fall 1993), pp. 8–18. Used with permis-
sion of Institutional Investor, Inc., http://www.iijournals.com. All
rights reserved. Updates courtesy of Adam Kolasinski.Portfolio betaInvestor 1Investor 10Market
portfolio02468101214161820Average risk premium, 1931−2014, %0 0.40.2 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0M
2
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5
678 9(^12) See J. R. Graham and C. R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial
Economics 60 (2001), pp. 187–243. A number of the managers surveyed reported using more than one method to estimate the cost of
capital. Seventy-three percent used the capital asset pricing model, while 39% stated they used the average historical stock return and
34% used the capital asset pricing model with some extra risk factors.
(^13) Betas were estimated using returns over the previous 60 months.