Capital Asset Pricing Model
According to Investopedia - "The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital."
Problems With the CAPM
There are several assumptions behind the CAPM formula that have been shown not to hold in reality. Modern financial theory rests on two assumptions:
(1) securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed);
(2) these markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments.
In real life....
In real market terms none of the these assumptions are 100% correct. Even when the trading terminals have become electronic, financial results are announced over the internet and TV , there still are inefficiencies in the dissemination of information.
Also all investors may not the equally inclined to collect the same type of information.
This creates bias.
Moreover what is the correctness in a management of a company providing for financial results and guidance of future performance.
There is vast information available on irregularities of companies - having hidden sensitive information from investors.
Flight to safety
In uncertain times, the investor behaviour is to move capital towards safety - which in the equity market terms can also be interpreted as - surety of returns.
Investors tend to believe that a company which has generated profits consistently, enjoys a market leaders position, has a superiors business model - will again provide for good numbers. This means it will again generate profits and make its business even more stronger.
And hence, even though these stocks are very expensive, money still moves to these stocks.
Let's look at some examples.
International Stocks
Apple stock - last 5 years
Microsoft stock - last 5 years
Indian Stocks
Reliance stock - last 5 years
TCS stock - last 5 years
Nestle India stock - last 5 years
Asian Paints stock - last 5 years
