CAPM is CRAP!
There is more to behavioural investing
Posted on October 3, 2007 by Richard Beddard
Filed Under Investing |
According to James Montier, an expert in behavioural investing, one of the fundamental tenets of modern financial theory is empirically bogus. Is theory finally catching up with reality?
Right after I wrote Monday’s blog, which didn’t take a swipe at behavioural investing but at the conclusion often drawn from it, that emotions render homo investus neandarthalis incapable of investing rationally, I emailed Wiley, the publisher, to ask for a review copy of James Montier’s new book ‘Behavioral Investing‘.
Wow! It’s just landed with a thud, and a I mean a THUD! On my desk. So the first Wow! Is for Wiley, and the speed with which the book arrived. The second is for size. This is no ‘Little Book of Behavioural Investing’, it’s 800 pages long.
I fear I might have bitten off more than I can chew. At twenty-five pages an hour, six hours a week (three train journeys into London and three out), allowing for the odd snooze, I might finish it in a couple of months. Is it worth it? (It had better be, or Wiley will be cross - 800 pages doesn’t come cheap).
From the first page of the first chapter:
Neuroscientists have recently uncovered two particular traits of significance to investors:
The first is that we are hard-wired for the short term…
Oh dear.
The second is that we appear to be hard-wired to herd…
Double dear. I don’t disagree, I just think these observations don’t get us very far. Just because we’re hard-wired doofuses, doesn’t mean we’re condemned to behave that way. Men are hard-wired to think about sex every six minutes, we’re told. It doesn’t mean we act on it.
More from Mr Montier:
The good news is that we continue to make brain cells pretty much throughout our lives. And our brains aren’t fixed forever, we can rearrange the neurons (a process called plasticity). We aren’t doomed, we can learn, but it isn’t easy!
Phew! I’m out of the woods, and so, if I might be so bold, is Mr Montier. If behavioural science has anything to tell investors, it has to show us how to avoid the psychological pitfalls that dog stock market practitioners.
As an investor I’m convinced that fundamentals + psychology = price, which is why I tend to buy value stocks - good companies when they are out of favour - and wait for them to recover. It’s a long-term strategy that stops me buying high, and selling low, with the rest of the herd.
That ‘equation’ is also why, as a journalist, I am interested in mechanical and semi-mechanical strategies that insulate investors from emotion by enforcing discipline on them. Strategies like:
- John Mulligan’s STAR system (regularly reviewed on the Interactive Investor mothership)
- Dr Keith Anderson’s naked pe ratio, regularly reviewed on this blog (here’s the last one)
- Professor Joel Greenblatt’s Magic Formula*1
By reading the book, I hope to learn whether the burgeoning field of behavioural investing validates these methods, augments them, or even replaces them.
James Montier’s book is written primarily for professional investors, he’s one of them. But it’s broken up into self-contained chapters, which appear to be entertainingly written. In any case, any book that has a chapter entitled CAPM is CRAP! And goes on to say:
The capital asset pricing model (CAPM) is insidious. It finds its way into all sorts to finance discussions. Every time you mention alpha and beta you are invoking the CAPM. Yet the model is empirically bogus. It doesn’t work, in any way, shape or form. Instead of obsessing about alpha, beta and tracking error it is high time we concentrated on generating total returns with acceptable levels of risks.
Gets my vote. (Graeme, are you listening :-)*2).
The only negatives so far, are a couple of typographical errors. There’s one in the quote above (and unless you can find two, it’s not mine). It’s not the typos that you can spot that you need to worry about of course, but the ones you can’t. But I’ll not be put off yet. I’m going to embark on a behavioural finance marathon, after all.
Footnotes:
- For irregular readers of the blog, Graeme is a fellow investment blogger. We have been known to differ on the usefulness of modern finance theory, and the ease with which an investor can beat the market
- More on magic formulae: Gurufocus’ Lonnie J Rush says there is a magic investing formula, and it’s simple as pie. Sadly though, most people still can’t follow it, because it means… you guessed it, going against the herd and sticking at it for the long-term.
- Mr Montier is a blogger, which is, of course, to his eternal credit.
Comments
9 Responses to “CAPM is CRAP!
There is more to behavioural investing”
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[…] Richard Beddard not only endorses a condemnation of CAPM, but he wants to know if I am reading. I say it is the worst valuation model, apart from all the others. […]
Hi Richard,
I will review the book for you if you do not have time
It actually sounds right up my street based on Mr. Montier’s blog.
Another quote from Ken Fishers book which is kind of relevant.
“… none of this will keep you from persisting in your old investing errors if you can’t control your brain. Investing is inherently counter intuitive”.
Ken Fishers recommended investing method (for us lowly mortals at least) is actually to use a ‘mechanical’ approach i.e. invest against an index and rebalance. However he stresses that you must also adapt the index to your needs based on ‘what you know that others do not’. I like the idea of using your own index, but like almost every rebalancing strategy ever described, there is a lot of vague details.
I thought the quote on CAPM was interesting because (I thought) it was specifically about generating total returns with an acceptable level of risk. Perhaps you could clarify this for me if you have time.
Many thanks as always
Robin, I’ll send you the book when I’m done with it, if you promise to review it for the blog (but bear in mind you might have to wait a while)!
Sadly, I don’t have it to hand (I’ve got to finish what I’m currently reading before I start lugging this heavyweight into work) so I can’t answer your question about CAPM, except so say my big hope is it depends how you define risk, which, I think is the nub of the issue.
Hi Richard,
I will be happy to write a review for the blog and return the book afterwards.
You are probably correct about the definition of risk being the key to the above statement about CAPM. I need to do some reading up on CAPM later. Looking at the formula briefly, it does seem a bit unreasonable to use a higher volatility to imply that you will get an expected higher return. It seems to me it should be able to go either way. The volatility should simply indicate the maximum magnitude of the expected return but not the direction.
Hi Richard and team. As you know I favour mechanical investment styles as I dont think many of us are naturally good traders.
I also find CAPM hollow…..my current beef is that Beta is focussed upon by some users as a relative index of performance and by other users as a relative index of volatility.
Has anyone else found this confusing?
Do they know which group’s view to favour?
Hi Ben, I have to agree with you. I am definitely not a natural trader and I suspect there are a lot more unnatural traders than natural ones out there
At the very least, everyone should have some benchmark to gauge their portfolio against which suggests some kind of mechanical element to their investing strategy.
However I would not use CAPM because I do not understand the maths behind it. From what I have managed to (vaguely) understand I would say it has three basic problems.
Firstly ‘beta’ is a very difficult idea to get you head around intuitively. It seems to me that beta is inherently unstable over shorter time periods. However, if you are using rebalancing to drive your returns, then any beta you are interested in are short term beta’s (short term meaning less than one year). I would also hazard a guess that any beta other than ‘one’ over both the short and long term would make the benchmark tracking unstable in any case.
Secondly, the formula depends on you choosing a benchmark. If the only way to use the formula reliably is to choose an index tracker (with beta equal to ‘one’), then you are dependant on choosing the right index and also on the people who constructed the index in the first place.
Finally the formula seems to force you to use the benchmark in a certain way, which basically says you need to invest in the benchmark for a long time to get the expected beta. However this is completely contrary to the idea of rebalancing which is a short term activity.
I might be talking nonsense as I am no mathematician, so do not read too much into this! I am just not going to use CRAPM myself
[…] previously wrote a defence of CAPM in reply to this post. Even given that the empirical empirical evidence shows that high beta portfolios do not generate […]
[…] first impressions were largely positive, as indeed are my thoughts a hundred pages in. But Robin must have heard me groaning under the […]
[…] that word ‘hard-wired‘ again. It’s repeated so often in the financial pages these days I’m convinced it […]