CAPM and Investment Decisions

939 Words Jan 12th, 2018 4 Pages
This is because this investment is non-compliant with the principle of additivity and framing effects are realized during decision making resulting in different descriptions of the same problem thus different choices. Besides these, there are several reasons that make the use of this model an unlikely choice for individual investment decisions.
Capital Asset Pricing Model is used to determine appropriate required rate of return for an asset during evaluations. CAPM takes into account asset sensitivities to non-diversifiable risks often represented by the quantity beta (β), expected return of the market as well as the expected return of a theoretical risk free asset (Jagannathan & McGrattan, 1995).
As a tool for valuing and selecting projects, CAPM's use is considered theoretically correct, once its assumptions are met. This model is one of the important advances in financial economics and is useful in corporate finance. Studies have been conducted to verify whether investment decision makers comply with the CAPM paradigms, and evidence shows that managers often violate the CAPM standards during capital budgeting decisions.
Therefore, it clear that CAPM-based capital budgeting criterion is unsound for both investment valuation and decision making. This is because the CAPM is biased against two principles of rationality; value additivity and…
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