THE VAST SHORTCOMINGS OF THE CAPITAL ASSET PRICING MODEL & ALTERNATIVES
May 20, 2009
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The Capital Asset Pricing Model is as precise at estimating risk as Moody's was for assesing sub-prime risk. There are several superior methods to determine risk for any given equity. But first let;s break down CAPM and expose the numerous shortcomings.
1) CAPM = Rf + B(Rp)
There is no such thing as "risk free" for 2 reasons: Inflation (especially the rampant rates in our near future) destroy the purchasing power of both a 10-year treasury as well as the interest earned. Even using a inflation protected yield distorts reality. It is determined using the Consumers Price Index which is an arbitrary basekt of goods that has been manipulated numerous time to downplay inflation (a great example was April's CPI (0%), if calculated as it was in 1980 would have been in excess of 6%. The risk free rate doesn'r exist in reality, rather only in text books. This, however, is a very small problem of this model.
BETA is bane of my investing existence! BETA is the volotaility of an given equity measured against one of the major benchmarks. This should only really be done using the Wilshire 5000 as to incorporate as much of the market as possible. But then the next problem presents itself: For example, if i run a regression for miscorsoft against this index, don't you have to exclude microsoft from the Wilshire before it is run? In other words you would be running a regression of microsoft against itself to a certain degree, thus skewing the R-square. Aside from that point, why is volotility a measure that when increased, also increased implied risk. The sheer fact an given equity flucutates widly, allows one to dollar cost average their way into a position on larger scales and could very likely reduce the average purchase price. One last note on Beta: it is a historic number, and last time i checked markets were extremely dynamic, not static as this would imply.
SO WHATS ARE SOME ALTERNATIVES? I personally begin with basic financial ration i.e current, quick, time interest earned, operating cash flow to liabilities, free cash flow % of net income, etc. A largely ignored but excellent measure is ALTMAN-Z (which has a great track record for detecting companies that would go bankrupt) and other alternatives to this model. Another model is the Beneish Model with calculates the proobability of accounting manipulation ( and like the Z-score, has a rather good track record). You should also incorporate your personal required rate of return as opposed to risk free. This is just one example of an alternative to the inherently flawed CAPM, which as I mentioned before is not practical in the real world.
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