The Limitations and Evolution of the CAPM Model

The Capital Asset Pricing Model (CAPM), first introduced by William Sharpe and others, has been an important part of modern finance. This model is based on a simple idea: the expected return of an asset depends on its market risk, as measured by beta. This idea is applied in many areas, such as estimating the cost of capital, managing portfolios, and evaluating investment performance. But over time, more data have shown that CAPM has limitations. It does not fully explain the differences in returns between different assets. As a result, new models incorporating more factors have been developed. These models add things like company size, book-to-market ratio, and past return trends (momentum). These models aim to deliver more reliable and accurate results. This study integrates theoretical analysis and empirical data to examine the effectiveness of the Capital Asset Pricing Model (CAPM) in typical scenarios. Furthermore, using historical return data and regression analysis, the study compares CAPM with several multifactor models. The results show that CAPM has some clear weaknesses. However, it retains its value: rather than discarding it, we can regard it as a starting point, upon which better models can be built to explain asset prices more effectively and align more closely with real-world data.