“Unfortunately—and I write this with a heavy heart—the CAPM is not just imperfect; it is so badly wrong that it is best ignored,” writes Ivo Welch (UCLA Anderson Graduate School of Management) in an article “The Cost of Capital: If Not the CAPM, Then What?” (click here for a download).
Why is CAPM still so prominent? Why is it still taught and used in practice so much? Welch’s comments are similar to those of Pablo Fernandez (University of Navarra), another well-respected academic in his paper “CAPM: An Absurd Model.” He found that academics still teach CAPM because it takes up a lot of class hours and there’s nothing to replace it. Welch agrees, saying it’s “we academics who committed the original sin” and became so “enamored” by the model that they “simply ignored the evidence.” CAPM “provides one basic prediction: high-beta stocks should outperform low-beta stocks on average, because high-beta stocks are riskier. Unfortunately, the data say the opposite,” Welch writes. He does offer some recommendations as to how analysts and investors can do better than CAPM.