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of
the
Markowitz
model
and
models
to
CAPM
assumes
homogeneous
expectations
therefore
all
that are driving the cross-sectional security returns that we are not
able to capture through beta. Time series violations are also
present, even after controlling for beta. For example, firms with high
P/E ratios have lower return, and stocks w/ high dividend yield have
higher returns.
When does the CAPM fail?
The CAPM may fail to capture other risks such as (1) distress risk
value stocks tend to be stocks that have underperformed in the past
thus could be in financial distress making them riskier, and (2)
liquidity risk small stocks are illiquid and may thus command a
higher premium.
There may also be behavioral biases against classes of stocks,
which have nothing to do w/ the reward-to-risk ratios on stocks.
The empirical failure of the CAPM suggests that more than one risk
factor are necessary to explain the cross-section of stock returns.
Limitations of the single factor model
By adopting the single index model, each asset is restricted to
having the same sensitivity to each risk factor. For example, if the
market reacts twice as much to surprises in GDP than in inflation, all
assets in the economy must react twice as much to surprises in GDP
than in inflation.
This is a very strong assumption different securities may differ in
their relative sensitivities to different risk factor, which is why we
need a multifactor model.