Limitations

of

the

Markowitz

model

and

models

to

overcome those limitations

The Markowitz portfolio selection model (1) derives the efficient
frontier of risk assets and (2) provides framework for optimally
combining risky assets. However, it doesnt provide guidance with
respect to the risk-return relationship for individual assets. The
CAPM extends the Markowitz model by aggregating the asset
demands implied by Markowitz investors to infer equilibrium
expected returns E(r) on risky assets. It includes the notions of
systematic and idiosyncratic risk.
Assumptions of the CAPM
Investors are price takers i.e. security prices are unaffected by
their individual trades
All investors have identical single period planning horizon
Investments are limited to:
o publicly traded financial assets
o risk free borrowing and lending.
No taxes and no transaction costs
All investors are rational i.e. minimum variance optimizers
Information is costless and freely available to all investors
Homogeneous expectations i.e. all investors interpret
information identically see the same mean and variances for
the same set of assets
Equilibrium implications of the CAPM
The

CAPM

assumes

homogeneous

expectations

therefore

all

investors will arrive at the same efficient frontier of risky assets.

Individual portfolio optimization will lead to all investors arriving at
the same optima risky portfolio (tangency portfolio/market portfolio)
on the efficient frontier. Each investor then mixes T with the risk-free
asset f according to personal risk aversion (proportion y invested in
T and 1-y in f).
The equilibrium implication of the CAPM means that aggregate
demand must equal aggregate supply for each asset i. Moreover,
the market wealth must equal the aggregate wealth of all investors,

since every asset is owned by some investor(s). In other words,

every investor wants to be on the CML.
The Security Market Line
The security market line plots the individual asset expected returns
as a function of beta.
Drawback of the Markowitz model
In order to implement the Markowitz model, a large number of
covariances is required. Due to the large number of calculations
required, estimation error is high and would render the model
almost useless. An index model of asset returns can be used
instead, as it requires a reduced number of inputs to estimate
covariances. By reducing the number of inputs, we hope to (1)
reduce calculations and (2) limit estimation errors.
Comparison of the index models to the Markowitz model is
the index model inferior to the Markowitz model?
The single index model places more restrictions on the structure of
asset return uncertainty. By splitting uncertainty into macro vs. firmrisk oversimplifies real-world uncertainty e.g. ignores industry-risk.
The optimal portfolio obtained via the single index model might be
inferior to the one obtained from the Markowitz model.
The index model and the CAPM
The index model is closely related to the CAPM. Thus, its practical
relevance depends to a great extent on the CAPMs empirical
validity. We can show that the beta in the index model equals the
beta in the CAPM. However, implications for alpha differ. The CAPM
implies that the alpha=0, in expectation, for each security, whereas
the Index Model implies that the realized value of alpha should be 0
on average across securities.
Empirical tests of the CAPM and its violation
While the CAPMs implications are qualitatively supported, empirical
tests do not support its quantitative predictions. Cross-sectional
violations are present even after accounting for beta. It should be
explained by the betas, however, there may be additional factors

that are driving the cross-sectional security returns that we are not
able to capture through beta. Time series violations are also
present, even after controlling for beta. For example, firms with high
P/E ratios have lower return, and stocks w/ high dividend yield have
higher returns.
When does the CAPM fail?
The CAPM may fail to capture other risks such as (1) distress risk
value stocks tend to be stocks that have underperformed in the past
thus could be in financial distress making them riskier, and (2)
liquidity risk small stocks are illiquid and may thus command a
higher premium.
There may also be behavioral biases against classes of stocks,
which have nothing to do w/ the reward-to-risk ratios on stocks.
The empirical failure of the CAPM suggests that more than one risk
factor are necessary to explain the cross-section of stock returns.
Limitations of the single factor model
By adopting the single index model, each asset is restricted to
having the same sensitivity to each risk factor. For example, if the
market reacts twice as much to surprises in GDP than in inflation, all
assets in the economy must react twice as much to surprises in GDP
than in inflation.
This is a very strong assumption different securities may differ in
their relative sensitivities to different risk factor, which is why we
need a multifactor model.