I’ll be blunt: beginners may want to skip this post.
I realize that many people in the investment industry look at the capital markets in a CAPM framework. In 1993, Eugene Fama and Kenneth French released their landmark paper The Cross Section of Expected Stock Returns which showed that, historically, a model that incorporated sensitivity to what are known as the “size” and “value” factors in addition to sensitivity to the “market” factor did a better job explaining portfolio returns across portfolios of different characteristics. CAPM, for reference, really only seemed to work for large, growthy portfolios. I know “growthy” is not a real word, but humour me. :)
I’ve written extensively on this “Fama French Three Factor” model (FFTFM), but should point out that recently a new model has been proposed that seems to do a better job explaining some anomalies that the FFTFM can’t. One of these factors is “momentum”: this is the tendency for stocks that have been falling to continue falling, or vice versa for stocks that have been rising to continue rising.
Other researchers are beginning to find data to support the notion that value stocks (represented by high book-to-market metrics) do not indeed compensate investors given the higher volatilities they exhibit. This would be a problem for the FFTFM as well which assumes the opposite.
So to that end, I’m including a link to a paper that proposes a newer model, the Neoclassical Three Factor Model which suggests a solution to the momentum and distressed firm anomalies. Click here to access the paper.
NOTE: CAPM, FFTFM and the Neoclassical Three Factor Models are just that: models. They are just attempts to explain stock market behaviour but realistically even if anyone could perfectly explain past stock market returns it would hold decreasingly little predictive behaviour on a go-forward basis as this new information would then be incorporated by the market, thus changing the very nature of market valuation techniques.