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The Failure of Neoclassical Financial Economics: CAPM and its Pillars as an Illustration

Journal 33: Technical Finance

Imad A. Moosa

It is argued that the CAPM and its variants and extensions are theoretically invalid, empirically unsupported, and practically useless. The efficient market hypothesis and the rational expectations hypothesis, which are two pillars of asset pricing models and neoclassical finance in general, have been invalidated by the advent of the global financial crisis and the development of alternative paradigms such as behavioral finance. It is also argued that the mushrooming of asset pricing models that bear no relevance to reality has been sustained by the excessive mathematization of finance and the use of improper econometric procedures, including data mining.

The capital asset pricing model (CAPM) and its extensions symbolize everything that is wrong with academic finance: models of financial markets and asset prices, the econometric testing of these models, and their perceived practical significance. Despite the global financial crisis, and the devastation it has inflicted on countries and individuals, it is still “business as usual” for the true believers – those who think that markets cannot fail and that finance is like physics, a science that can produce reliable predictive models. Hundreds of papers have been written on the CAPM and its variants/extensions, but little concern has been expressed about the tendency of finance academics to squander a big portion of their intellectual capital on this endeavor. Even worse, some brilliant mathematicians, physicists, and engineers have been doing the same, writing about the CAPM when they could do much better in terms of contributing to human knowledge and improving technology.

The CAPM and its foundations lie at the heart of the orthodoxy of the Chicago economics, including the foundation that markets are fundamentally rational – hence surrendering to market tyranny is the right thing to do. The model has been portrayed as a “revolutionary idea” that is associated with another “revolutionary idea” – that of the efficient market hypothesis. The true believers have been seeking salvation by adding other explanatory variables to the CAPM, without any explicit theory or even intuition, hoping that data mining will produce a more appealing “gourmet” version of the model.

The objective of this paper is to evaluate CAPM, its foundations, and the means of testing it in light of recent developments in academia and in practice.


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