The capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses.1 The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications. The CAPM’s empirical problems may reflect theoretical failings, the result of many simplifying assumptions. But they may also be caused by difficulties in implementing valid tests of the model. For example, the CAPM says that the risk of a stock should be measured relative to a comprehensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate, and human capital. Even if we ∗

Eugene F. Fama (eugene.fama@gsb.uchicago.edu) is Robert R. McCormick Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago, Chicago, Illinois. Kenneth R. French (kfrench@dartmouth.edu) is Carl E. and Catherine M. Heidt Professor of Finance, Tuck School of Business, Dartmouth College, Hanover, New Hampshire. We gratefully acknowledge the comments of John Cochrane, George Constantinides, Richard Leftwich, Tobias Moskowitz, Andrei Shleifer, René Stulz, and Timothy Taylor. 1

Although every asset pricing model is a capital asset pricing model, the finance profession reserves the acronym CAPM for the specific model of Sharpe (1964), Lintner (1965), and Black (1972) discussed here. Thus, throughout the paper we refer to the Sharpe – Lintner – Black model as the CAPM.

take a narrow view of the model and limit its purview to traded financial assets, is it legitimate to further limit the market portfolio to U.S. common stocks (a typical choice), or should the market be expanded to include bonds, and other financial assets, perhaps around the world? In the end, we argue that whether the model’s problems reflect weaknesses in the theory or in its empirical implementation, the failure of the CAPM in empirical tests implies that most applications of the model are invalid. We begin by outlining the logic of the CAPM, focusing on its predictions about risk and expected return. We then review the history of empirical work and what it says about

shortcomings of the CAPM that pose challenges to be explained by alternative models.

The Logic of the CAPM The CAPM builds on the model of portfolio choice developed by Harry Markowitz (1959). In Markowitz’s model, an investor selects a portfolio at time t-1 that produces a stochastic return at t. The model assumes investors are risk averse and, when choosing among portfolios, they care only about the mean and variance of their one-period investment return. As a result, investors choose “mean-variance-efficient” portfolios, in the sense that the portfolios: 1) minimize the variance of portfolio return, given expected return, and 2) maximize expected return, given variance. Thus, the Markowitz approach is often called a “mean-variance model.” The portfolio model provides an algebraic condition on asset weights in mean-varianceefficient portfolios. The CAPM turns this algebraic statement into a testable prediction about the relation between risk and expected return by identifying a portfolio that must be efficient if asset prices are to clear the market of all assets. Sharpe (1964) and Lintner (1965) add two key...

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