Investment Policy Implications of the Capital Asset Pricing Model



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    • Simon Fraser University. The article was completed while the author was visiting at the University of California, Berkeley. The author thanks Simon Fraser University's President's Research Fund for supporting the research and the Institute of Business and Economic Research, University of California, Berkeley for providing clerical assistance in preparing the manuscript. He also thanks Nils Hakansson, John Herzog, the editor, and the referee, Richard Pettit, for many valuable comments and Paul Newton for computational assistance.


The results of previous generalized Security Market Line (SML) tests of the Mean Variance (MV) and Linear Risk Tolerance (LRT) Capital Asset Pricing Models indicate that the models are empirically identical. A very widely accepted, but technically incorrect, explanation for the results is that with normal return distributions all expected utility maximizing riskaverse investors will pick MV portfolios. The paper shows that the generalized SML tests cannot distinguish between the MV model and a much wider variety of power utility LRT models than has previously been entertained. On the other hand, with approximately normal, or real world, return distributions the investment policies of the various models are shown to be different from each other, and from the MV policy in particular. To the extent the results of the portfolio selection calculations are robust, the results of, and implications drawn from, the tests of the macro pricing relations are not based on firm micro foundations.