Market Efficiency: A Theoretical Distinction and So What?

With the aid of some simplifying assumptions, the capital asset pricing model comes to dramatic conclusions about practical matters, such as how to choose an investment portfolio and how to value financial assets. As illustrated in this article, when one particular, clearly unrealistic CAPM assumption is replaced by a more real-world version, some of the dramatic, practical conclusions of CAPM no longer follow. This result has implications for financial practice, research, and pedagogy. The capital asset pricing model is an elegant theory. With the aid of some simplifying assumptions, the CAPM comes to dramatic conclusions about such practical matters as how to choose an investment portfolio, how to forecast expected returns, and how to value financial assets with suitable adjustments for risk. These practical implications of the CAPM follow from two basic CAPM conclusions: (1) that the market portfolio—that is, a portfolio that holds securities in proportion to their market capitalization—is an efficient portfolio and (2) that an asset's expected return has a simple (linear) relationship to its beta.One of the simplifying assumptions of the original CAPM is that any investor can borrow without limit at the risk-free rate. As this article illustrates, the two basic CAPM conclusions no longer follow if this assumption of unlimited borrowing is replaced with that of limited or no borrowing. When borrowing is restricted, the market portfolio can be quite inefficient. Also, expected returns are not linearly related to betas.An alternate CAPM replaces the assumption of unlimited borrowing with the assumption that the investor can sell short and use the proceeds of the sale to buy long positions, without limit. In effect, it assumes that the investor can deposit $1,000 with a broker, short $1,000,000 worth of Security A, and use the proceeds of the short plus the deposit to buy $1,001,000 worth of Security B. This assumption is no more realistic than the assumption of unlimited borrowing.This alternate CAPM, like the original CAPM, implies that the market portfolio is an efficient portfolio and that expected returns are linearly related to betas. As I explain in this article, if the assumption that short proceeds can be used to buy long positions is replaced by a more real-world description of what is permitted in long-short portfolios, again, the two basic CAPM conclusions do not follow. In other words, the market portfolio may be substantially inefficient and expected returns are not linearly related to betas. These market inefficiencies would not be arbitraged away if some investors could borrow without limit, or short and use the proceeds to buy long positions without limit, while other investors could not.Thus, some of the “well-known” “conclusions” of “modern financial theory” disappear when the other assumptions of the theory are combined with more realistic descriptions of investor constraints. In particular, commonly used rules for risk adjustment and asset valuation are called into question.