Undiminished Praise of a Vacuous Theory

The CAPM is still considered a first-order intellectual achievement, in spite of the current thought leaders also describing it as being “empirically vacuous” (Fama and French, 2006) or that “having a low, middle or high beta does not matter; the expected return is the same” (Ross, 1993).1 In­ deed, I would say the situation is worse, as volatility and beta are generally negatively correlated with returns. Its extensions have proven equally impoverished. There’s clearly a greater truth at work in this case, the greater truth is that some asset pricing model will work, and it should have the neat CAPM properties of being linear in risk factors, not include residual risk, and include something very like the market as one of the prominent factors. The theory has little equal by way of praise from economists, who see the success of derivatives as proving the risk-reward portion of academic finance as manifestly fruitful. I doubt even Keynesianism had such high approval ratings at its apex. But the flaw of the CAPM isn’t that it is not perfect, but rather does not predict relative returns, even slightly, quite different from the flaws of Newtonian mechanics, which become apparent near the speed of light. The golden age of the CAPM was from 1972 to 1992, from Fama’s initial confirmation of the theory to his rejection of it. Not that it ever really worked, or that portfolio managers ever mainly relied on beta in constructing portfolios. No, it was that among experts, the belief was that the CAPM was an innovation in our abstract understanding that would stand the test of time like Euclid’s Elements. Refined, extended, to be sure, but never junked. The concurrent development of the APT, and the general equilibrium SDF approach, were merely extensions. To the extent CAPM had difficulties; these more general approaches would fix them, but the basic ideas of the CAPM were paramount: linearity in pricing, and the positive premium of some systematic risk factors. It was further assumed that the