Figure A-l

The Capital Market Line

Marlcowitz Efficient Frontier

Risk

1. There are no transaction costs in buying or selling stocks or other investments. This includes not only commissions, but also the spread that exists between the bid and asking price. SpeciaUsts who make their money on the eighth or quarter spreads between the bid-ask spread, Nasdaq market-makers whose spreads are far higher, and, oh, yes, the entire brokerage industry, simply disappear, or become philanthropic organizations. Not bad for starters, but wait-the assumptions get better.

2. An investor can take any position in a stock that he wishes, regardless of its size, without affecting the market price. He can, for example, buy a dollars worth of Intel or a billion dollars of it. Robert Stansky, the manager of the $63 billion Fidelity Magellan Fund, would cheer at the news, as it would make his life a heck of a lot easier. I have trouble, at times, buying or selling positions for my clients whose assets total only several billions of dollars, so if this academic pronouncement were true, my hat would also be in the air.

While no single investors actions affect prices, the theorists continue, investors, in total, determine prices by their combined actions.

3. The investor does not consider taxes in making decisions and is indifferent to receiving dividends or capital gains.

4. Investors are risk averse; they will demand greater return for a higher level of volatility.

5. Investors seek to control risk through diversification of their holdings.

6. Investors, as a group, look at risk-return relationships over similar time horizons. In other words, a speculator and a long-term investor allow almost identical time periods for their investments to work out. If I am a day trader, trying to make a quick buck by buying and selling, and you are a long-term investor, the professors say, the amount of time we give an investment to work out is exactiy the same.

7. Investors, as a group, have similar views on how they measure risk. This assumes all investors have identical expectations with respect to the necessary inputs for a stock or portfolio decision.

If you can live with the initial five, these last two assumptions are doozies. Assumptions 6 and 7 suggest that each and every individual has the same time horizon and analyzes the outiook for every stock, or the market as a whole, in a similar manner. We need only look at First Call, a service that reports analyst recommendations, or the brokerage house reports themselves, to see major differences in opinion among various brokerage research departments. There is no evidence of homogeneity of investor expectations about stocks. This also brings up the question of why we buy or sell securities at all, since we all have the same analytical framework. But bear with me-theres more.

8. All assets, including human capital, can be bought and sold on the market.

9. Investors, as seen, can lend or borrow at the 91-day T-bill rate- tiie risk-free rate-and can also sell short without restriction.

You can see at a glance that most of the assumptions behind the CAPM model do not come close to reality-at least on this planet. First of all, nobody but Uncle Sam gets the risk-free rate of return. If Microsoft or General Motors cant get it, how can you or I? Everyone else pays slightly to significantly higher interest costs. Second, most institutional investors are restricted in their ability to borrow, while most individual investors are reluctant to borrow at all. The assumption that the investor does not consider taxes in making decisions is far-fetched. In

the real world, capital gains are such a "minor issue" that virtually every Presidential election in the last 40 years has seen major pressure by Republican candidates to lower capital gains taxes. If investors do not mind paying regular income taxes, one might ask, why do we have a trillion-dollar tax-free municipal bond industry?

Large investors certainly affect the prices of stocks with their buy and sell decisions, and it is certainly not reasonable to assume the trader who tiiinks in terms of hours or days will have the same expectation of future value as an investor looking years ahead. The above sampling of academic reasoning, choice as it may be, is only the hors doeuvre; the risk assumptions of Markowitz, Sharpe, Lintner, Mossin, et al., may be even more difficuh to accept, as we saw in chapter 14.

But it is precisely this complicated statistical formulation, built upon a logical briar patch, that allowed a theory like this to be formulated at all. If the assumptions were looked at on their own, separated from the formidable equations, the theorists might have a hard time maintaining credibility. In fact, the assumptions were so removed from reality that it took less than 20 years for the theory to be discredited by some of its strongest original proponents.

For the researchers, faith reigns supreme. Most theorists argue diat tiiese assumptions are close enough to reality to make important inferences about the behavior of stocks. They draw the conclusion that individual securities and the market as a whole are fairly priced according to the risks associated with owning them. The dieorists advise, therefore, that investors focus their main attention on the "risk profiles" of dieir portfolios. That is, they should not expect to eam higher retums without taking on additional risk, as Sha e, et al., have defined it, and if they want a lower risk profile, they will have to accept lower retums.

The theorists will counter critics of their assumptions by asking, "How much is reality distorted by making these assumptions? What conclusions about investment markets do they lead to, and do these conclusions seem to describe the actual performance of these markets?"

In conclusion, they emphatically state, "The final test of a model is not how reasonable the assumptions behind it appear to be, but how well the model actually works." Elton and Gmber, two well-regarded researchers, state that "despite die stringent assumptions and the simplicity of the model, it does an amazingly good job of describing prices in capital markets." This is the major defense, not only of modem portfolio theory, but also of efficient markets themselves. At this point the reader should be able to assess how accurate the last statement might be.