Size, Momentum, and Alpha: When CAPM Falls Short

Imagine the stock market as a vast ocean, and each stock is a boat sailing on it. The Capital Asset Pricing Model, or CAPM, is like a simple weather forecast for this ocean. It’s a model that tries to predict how much return you should expect from a stock, based on how risky that stock is compared to the overall market.

CAPM says that the only risk you should be rewarded for taking in the stock market is what we call systematic risk, or market risk. Think of systematic risk like a big wave that affects all boats in the ocean to some extent. This is the risk you can’t diversify away, no matter how many different boats or stocks you own. CAPM measures this systematic risk with something called beta. A stock with a beta of one is expected to move with the market, a beta greater than one is expected to be more volatile than the market, and a beta less than one is expected to be less volatile. According to CAPM, the higher the beta, the higher the expected return, because investors demand more compensation for taking on more systematic risk.

Now, let’s talk about ‘alpha’. In our ocean analogy, alpha would be like finding a hidden current that pushes your boat faster than the predicted wind and waves. In investment terms, alpha represents returns above and beyond what is expected based on the stock’s beta and the overall market conditions, according to CAPM. A positive alpha is considered good – it means your investment strategy is outperforming what the simple CAPM model would predict.

Here’s where things get interesting and challenge the simplicity of CAPM. Over the years, researchers have discovered investment strategies based on factors like company size and stock price momentum that seem to consistently generate positive alphas.

Let’s consider the ‘size’ effect. This strategy is based on the observation that, on average, stocks of smaller companies tend to outperform stocks of larger companies over long periods. It’s like finding that smaller fishing boats, on average, bring in a bigger catch than the giant corporate trawlers, even after accounting for the overall ocean conditions. If you build a portfolio that systematically invests more in smaller companies, you might find that it generates a positive alpha, meaning it earns returns consistently higher than what CAPM predicts based on its beta.

Then there’s the ‘momentum’ effect. This strategy is based on the idea that stocks that have performed well recently tend to continue to perform well in the near future. It’s like noticing that boats that are already moving quickly tend to keep moving quickly for a while. Imagine investing in stocks that have been ‘winning’ lately, those whose prices have been going up. A momentum strategy often involves buying stocks that have had strong past returns and selling stocks that have had weak past returns. Empirical evidence suggests that momentum strategies, too, can generate persistent positive alphas.

The problem these size and momentum strategies pose for CAPM is this: if CAPM is a complete and accurate model of how stock prices are determined, then any systematic, predictable extra return, like a positive alpha, should not exist, or at least not persist over time. CAPM suggests that if you are taking on more risk, it should be systematic risk, which is already accounted for by beta. However, the positive alphas from size and momentum strategies appear to be persistent and not fully explained by systematic risk as measured by beta in the simple CAPM.

This suggests that CAPM might be too simple. It might be missing some important factors or types of risk that investors are actually being rewarded for taking. Perhaps there are other kinds of risks, beyond just market risk, that are relevant for explaining stock returns. For example, smaller companies might be riskier in ways that beta doesn’t fully capture, or momentum might be related to behavioral biases in the market that CAPM doesn’t account for.

The persistent positive alphas from size and momentum strategies haven’t invalidated CAPM entirely. CAPM is still a useful starting point and a fundamental concept in finance. However, these anomalies have prompted the development of more sophisticated asset pricing models, like multi-factor models, which attempt to incorporate factors like size and momentum, and others, to better explain and predict stock returns and address the limitations of the single-factor CAPM. Essentially, these findings suggest that the weather forecast for the stock market is more complex than CAPM initially suggested, and we need more detailed models to understand all the currents and winds that influence investment returns.