CAPM is C.R.A.P.: Dresdner Kleinwort Economist
| Jan 31st, 2007 | Filed under: CAPM / Alpha Theory | By: Alpha Male |
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“CAPM is CRAP, or, The Dead Parrot Lives”
By: James Montier, Dresdner Kleinwort
Published: January 29, 2007, John Mauldin’s “Outside the Box”
John Mauldin is a big fan of James Montier, the 34 year old Dresdner Kleinwort economist who literally wrote the book on behavioral finance. Montier also wrote a chapter in Mauldin’s 2006 book “Just One Thing” and Mauldin re-printed Montier’s musings a couple of times on his website last year. Montier seems like an interesting guy and we enjoy his irreverent take on modern finance – like this one…
In this comprehensive yet very readable article Montier rails against the CAPM, calling it “(C)ompletely (R)edundant (A)sset (P)ricing”. While his facts are irrefutable, their interpretation leaves room for disagreement. In other words, the exact fecal count of CAPM remains unknown. But whether you agree with his conclusion or not, you will probably find this essay an interesting read.
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From a loyal AllAboutAlpha reader: This scatalogical piece is very interesting and in general I agree with it. His conclusion does bring us back to the central thesis of alpha centric investing though, which is irrefutable in its logic and is expressed so well by Ineichen. Problem is that every discipline has to start off with a straw man. Economists use “perfect competition”, geographers, the “isotonic plane” and lawyers, the “rational” man. We have CAPM based on “efficient markets”. The point is that we need a standard of perfection to tear down piece by piece to better understand how a system works. The danger is believing the straw man is reality… (AM: excellent point…and *superb* usage of the rather rare word “scatological”)
[...] Dresdner Kleinwort economist James Montier refered to this article in a recent piece. As Montier pointed out, Vuolteenaho argues that low beta stocks outperform higher beta stocks on a risk-adjusted basis (according to Montier’s own research, they may even outperform on an absolute basis). Vuolteenaho makes the logical step from this conclusion to the construction of a beta-neutral portfolio consisting of long positions in low beta names and short positions in high beta names. If this portfolio has a positive gross return, then “CAPM is C.R.A.P.” (to use Montier’s technical jargon). As this chart copied from the report shows, the CAPM seems especially stinky recently (the “late sample” = 1963-2001 while the “early sample” = 1927-1963). [...]
[...] The weekly investment newsletter “Outside the Box” picks up where a previous edition left off – with James Montier’s assertion that “CAPM is CRAP“. This week’s edition contains an interview with Peter Bernstein and James Montier conducted by Kathryn Welling.  As newsletter editor John Mauldin correctly observes, the article is “double the length of normal”.  Mauldin bills the interview as “Bernstein taking on (Montier’s) criticism of CAPM”. But unfortunately for those pining for a grudge-match (like us), there seems to be a lot of agreement between Montier and Bernstein. [...]
Anybody who has done any kind of quantitative research and portfolio construction especially in the equity space knows CAPM falls flat on its face, I don’t see anything new here.