The conventional models for risk and return in finance (CAPM, arbitrage pricing model and even multi-factor models) start by making assumptions about how investors behave and how markets work to derive models that measure risk and link those measures to expected returns. While these models have the advantage of a foundation in economic theory, they seem to fall short in explaining differences in returns across investments. The reasons for the failure of these models run the gamut: the assumptions made about markets are unrealistic (no transactions costs, perfect information) and investors don't behave rationally (and behavioral finance research provides ample evidence of this).
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 2: Proxy…
Alternatives to the CAPM: Part 2: Proxy Models
The conventional models for risk and return in finance (CAPM, arbitrage pricing model and even multi-factor models) start by making assumptions about how investors behave and how markets work to derive models that measure risk and link those measures to expected returns. While these models have the advantage of a foundation in economic theory, they seem to fall short in explaining differences in returns across investments. The reasons for the failure of these models run the gamut: the assumptions made about markets are unrealistic (no transactions costs, perfect information) and investors don't behave rationally (and behavioral finance research provides ample evidence of this).