Criticism on Capital Asset Pricing Model

criticism on CAPM

Criticism on Capital Asset Pricing Model

It is pertinent to mention here that the CAPM theory is about the real world; but it does not describe the real world fully.

Richard Roll, in the Journal of Financial Economics, argued that, because it is almost impractical to develop a portfolio that includes every single security (called a true market portfolio), any test of the CAPM that uses a market proxy (e.g. FTSE 100, DAX, CAC 40) will be testing that specific portfolio, and not the “true market portfolio”.

Capital Asset Pricing Model is empirically un-testable because the market portfolio on which it is based is unobservable.

Whenever we implement CAPM test that use market proxies, we will have to face this criticism.

CAPM is used for single-period though it can be used for multi-period but the assumptions on which it is based decrease the reliance upon that model

• CAPM does not account for transaction costs.

• Betas used in this model based on large number of observations but all related to the past, hence not reliable fully for making future investment decisions.

• It is often quite difficult to find the (rm – rf) or even the rf which is itself probable to be differ for macroeconomic reasons.

CAP Model depends on an efficient investment market and if this market exhibits imperfections, this would not help the investors to eliminate specific risk from their portfolios.

• Despite all critics, CAMP is getting popularity among investors all over the world due to its positive aspects of its workings. So it is considered as a useful tool by the investors for having it in their investment appraisal kit.

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