The “Capital Asset Pricing Model” (CAPM) Dominates MBA Schools Because of Its Relation to the “Efficient Markets Hypothesis”

The CAPM was to dominate academic finance for a long time. The key to its success was its unreserved adoption by the financial economists of the Chicago school, in conjunction with the closely related notion of the Efficient Markets Hypothesis. They defended the CAPM with religious zeal, and most business schools were soon teaching it as established orthodoxy, cranking out tens of thousands of MBAs a year who didn’t really understand the CAPM but who knew nothing better. . . .

In 1977 Richard Roll published a devastating critique that undermined the CAPM by showing that the market portfolio could never be reliably identified. Roll soon had people asking if beta was dead, but still the CAPM orthodoxy dismissed him as a spoilsport and the CAPM party continued for a little while longer.

The end finally came with a study by Eugene Fama and Kenneth French published in 1993, which showed that the beta was not related to stock market returns. This refuted the most basic prediction of the CAPM, namely, that stock market returns should be positively related to their betas. The bloody beta was useless. People were now mischievously asking if beta was dead, again.

From a purely scientific point of view, the Fama and French study was merely the latest in a long series of studies that undermined the scientific respectability of the CAPM. Its significance however was not in its results — although it should have been — but in its authorship. Fama, the inventor of the Efficient Markets Hypothesis, of which more below, was a key figure in the development of the CAPM itself. Thus, one of the key pillars of Modern Financial Theory was renounced by one of its principal creators.

—Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 71-72.