Efficient Markets vs. CAPM

by: Eric Falkenstein

The 'myth' of the rational markets suggests a straw man argument in practice, a position no one argues, but popular discussion and pandering authors discuss endlessly. If you think rationality implies perfection, or an absence of market declines, you are wrong, so don't waste too much time on this precious insight, it's like discovering that nature AND nurture affect IQ.

It is important to remember that while academics, almost exclusively economists, believe some form of market efficiency, most non-economists don't. Back in the 1970s and 80s when index funds were being introduced, most leading magazines lambasted the idea, noting how stupid an index fund was because people like Warren Buffett or Peter Lynch prove this is suboptimal. Thus, John Bogle (head of Vanguard) had to fight to get his board to accept an index fund, and this while he was CEO. Even today index funds are a small portion (about 15%, depending on how you count it) of equity investors.

In my book Finding Alpha (which has a short SSRN summary article here), I note that unlike Efficient Markets Hypothesis, which has never been popular with regular people, the Capital Asset Pricing Model has been warmly regarded since inception. The picture above shows the cover of Institution Investor magazine in 1971 discussing 'The Beta Cult' as if it were a done deal. The first empirical confirmation had yet to even be published. Of course, this confirmation (by Black, Jensen and Scholes ('72), Fama and MacBeth ('73), and Blume and Friend ('73)) was spurious, meticulously correcting for 'errors in variables', but totally blowing it on the omitted variable of size, which itself proxied measurement error issues related to delistings.

Why does the CAPM and its derivatives get a pass, whereas the Efficient Markets Hypothesis does not? Both rely on rational investors, though they are independent theories (neither implies the other). I think the efficient markets hypothesis plays into an easier caricature that is too easy to adopt, which is unfortunate, because as a guideline, the implication of the EMH is a much better approximation of reality than the CAPM (or the SDF or APT). That is, no measure of risk linearly, positively, relates to returns as a first approximation. In contrast, most investors lose money the more they trade, and their deviations from the market do not, on average, have alpha. See a small discussion from my video 3 on my book Finding Alpha:



So all you non-economists so self-satisfied as to not believe that markets are perfect, have fun taking on idiosyncratic risk for an extra 100 basis points a year. Way to stick to those smug economists.