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Diamonds In The Dust

How CAPM Has Hurt A Generation Of Indian Investors?

Over the last twenty years, equities have generated a 13%% compounded return (measured by the returns on the Nifty50 Total Return Index). And some selected portfolios, such as the ones shown in the book Coffee Can Investing: The Low-Risk Route to Stupendous Wealth, has generated compounded annual returns in excess of 20% over twenty years. However, investments in equities also suffer from some of the same problems discussed above, the main being the lack of access to sound and trusted advice. This leads to investors taking on undue risk while building their equity portfolios. Chasing stocks in sectors that are in favour, buying cyclical stocks without appreciating the underlying drivers of cyclicality, and trading in and out of stocks based on punts on the outcome of short-term events, are some of the ways these risks manifest in investors’ portfolios. A key reason for this is the reliance on conventional financial theory, particularly the capital asset pricing model (CAPM), which has shaped the world view of many investment advisors.


But how has CAPM hurt a generation of Indian investors?


There are many delusional theories in finance. One of these is the Efficient Markets Hypothesis (EMH), which contends that since stock prices efficiently discount all the available information, it is impossible to beat the market. Another is the Capital Asset Pricing Model (CAPM), which claims that the returns from stock will be directly proportional to the systematic risk (or beta) represented by the stock.


Whilst Warren Buffett’s rubbishing of the EMH in a famous speech delivered in 1984 at Columbia University is well-known, CAPM is still taught in classrooms worldwide—thanks to the pseudo-science peddled by business schools—including in India. But unfortunately, CAPM is even less applicable in this country than in America.


So, what is CAPM and just why is it so damaging? Investopedia explains CAPM this way:


The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks.

CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and the cost of capital.


The formula for calculating the expected return of an asset given its risk is as follows:

ER i = R f + β i (ER m − R f)



ER i =expected return of investment
R f =risk-free rate
β i =beta of the investment
(ER m − R f) =market risk premium


Investors expect to be compensated for risk and the time value of money.


The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.


The beta of a potential investment measures how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one.


Conversely, if a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.


A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate they can use to find the value of an asset.


Following CAPM in India leads investors to cause self-damage. The investor believes that higher returns are proportional to higher risk (measured in CAPM by higher beta).


In short, not only is there NO POSITIVE relationship between beta and stock-level returns, there seems to be strong evidence that lower beta leads to higher returns. This finding also holds if, rather than using beta as a proxy for risk, one uses share price volatility (as measured by the standard deviation of monthly returns divided by the compounded annual returns over the corresponding period). Specifically, there is a STRONG NEGATIVE correlation between share price volatility and returns, i.e., companies whose share prices are less volatile give significantly better returns over twenty, ten, five, and even three years.


Therefore, the data shows that CAPM is completely useless in India—not only do the highest-risk stocks (high-beta stocks) NOT deliver the highest returns, but the stocks that deliver the best returns are low-risk stocks (i.e., low-beta stocks with low share price volatility). So, why doesn’t CAPM work in India? Because the assumptions underlying CAPM is unrealistic, even in a developed market like the US.


In an emerging market like India, these assumptions are on the verge of being delusional. For example, CAPM assumes that all investors have free access to all information at no cost. This makes no sense in a market like India, where even institutional investors have little or no idea of the accounting fraud that most companies engage in.


Another example of an absurd assumption embedded in CAPM is that there are no taxes and no transaction costs. In reality, short-term capital gains tax is 15%, and even for Nifty50 stocks, brokerage costs plus price-impact costs are around 0.5% for institutional investors. So, if CAPM does not work in India, what does? Crushing risk works in India. Let us dig deep into the concept in the next section. 

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