CAPM Strengths and Weaknesses

Written by malachi lloyd green
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CAPM Strengths and Weaknesses
The CAPM is useful in the world of stock markets and securities. (Kick Images/Photodisc/Getty Images)

The Capital Asset Pricing Model (CAPM) is used in economics as a method of putting a valuation on securities, stocks and assets by evaluating the level of risk, as well as predicting the rate of return from these factors. The idea of the model is based on the theory that investors wish to be adequately compensated for the risk involved in investing their money and the value of their investment over time.

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Assumptions

The assumptions of any economic model can be seen as a double-edged sword: They set out the foundations that are key to understanding the model. Due to these assumptions, they can also be narrow and inadequate for explaining situations in real life, where circumstances are shifting rapidly. The CAPM assumes that there will be no arbitrage (i.e. the ability to indefinitely buy assets from one source in order to sell them to another source for short-term profit gain), that all actors (i.e. investors) are rational in their reasoning and expectations, and that the capital markets are run in an efficient way.

Access to Information

Another assumption made by the model is that all investors will have the same level of access to relevant information and will all agree with the level of risk and rate of return from all assets, securities or stocks. This is known as a homogeneous expectations assumption. When this model talks about the same level of information, it means publicly available records that any investor can study in order to make an informed investment decision. In that sense, this part of the CAPM can be seen as a strength and a weakness: a strength as it is consistent with the real world of investment, and a weakness as it discounts investors who may have more information than others, possibly through their professional lives.

Assumptions in Theory

The model, despite the research attributed to it, does have its weaknesses. First and foremost, it is an economic model that is based on a series of assumptions. Therefore, the theories put forward are measured against cases that share the same environmental factors, with perceived test subjects who are usually assumed to be rational actors aiming for a similarly desirable conclusion. As with any economic model, such restrictions are accurate in theory but often don't transfer as well to real-life situations, where the environment of the economic market is always changing.

Taxation and Transactions

One of the more obvious weaknesses of the model comes from the assumption that it isn't subject to either taxes or transaction costs. As this couldn't be properly tested in an unbiased way, it only serves to highlight the difficulties faced by economic models.

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