Although asset pricing models are flawed they can still be useful, according to a recent Advisor Perspectives article by Buckingham Strategic Wealth chief research officer Larry Swedroe.
Citing various models including the capital asset pricing model (CAPM), the three-factor Fama-French model and the Carhart four-factor model, Swedroe writes, “The fact that we have seen keen competition to improve existing models should not surprise us. One reason is that, by definition, all models are flawed. If they were perfect representations of the way the world worked, we would have laws (not models), like we have in physics.” He adds, “Though models are flawed, that doesn’t mean they’re absent of value.”
Swedroe suggests that instead of viewing pricing models as a perfect indicator of how financial markets behave that we view them as “engines that advance our understanding of how markets operate and how prices are set,” which is why, he argues, “we continue to see efforts to improve on existing models.”
He cites a 2020 study that compares pricing models across 50 non-U.S. developed and emerging market countries for the period from July 1990 through October 2018 and found the following:
- Momentum showed the highest average return while size showed the smallest average return.
- The CAPM is “dominated by all other models” and explains about two thirds of the variation in returns of well-diversified portfolios.
- “The patterns documented for markets outside the U.S. are similar to those reported for the U.S.”
- The results of the study were described as robust across subperiods, global regions and “methodological changes.”
The article concludes that, “through their research, financial economists continue to advance our understanding of how financial markets work and how prices are set,” adding, “the competition to find superior models is what advances our understanding not only of the markets but also about which factors to focus on when selecting the most appropriate investment vehicles and developing portfolios.”