t as a whole may decline. The nondiversifiable risk arises from macroeconomic factors which influence all assets at the same time. As an example, during the credit-crunch most companies tend to have low profits and negative cash flows.
While the assumptions held by the CAPM allow it to focus on the relationship between return and systematic risk, the idealised world proposed by the assumptions is clearly not the same as the real world in which investment decisions are mostly made by companies and individual. The extent to which these assumptions are not met with the real world will affect the validity of the CAPM[6].
These assumptions are a major part of classical economic doctrine. Indeed, they are the standard assumptions of a perfect market, and their merits have been discussed widely in the literature. William Sharpe emphasises this by saying needless to say, these are highly restrictive and undoubtedly unrealistic assumptions[7] Indeed, real-world capital markets are undoubtedly not perfect. Even though, well-developed stock markets do exhibit high efficiency; there is an extent for stock market securities to be mispriced.
The CAPM assumes no transaction costs, in the way that trading is costless and investments are priced to all fall on the capital market line. However, we know that many investments such as the acquisition of a small business for example, involve significant transaction costs. Furthermore, under CAPM, investment trading is tax-free and returns are unaffected by taxes. But most of the returns such as dividends and capital gains are taxed in a different way and thus, forces investors to consider taxes. Additionally, many investment transactions have capital gains taxes. In reality, the different investors are also taxed differently according to their status: individuals versus pensions plans. Moreover, the assumption that investors hold diversified portfolios means that all investors want to hold a portfolio which reflects the stock market as a whole, the market portfolio. However, it is impossible to own the market portfolio itself.
Under CAPM, investors can borrow money at risk-free rates. Risk-free asset is an asset which has a certain future return, such as treasuries (T-bills). This is done to increase the number of risk assets in a portfolio. However, in reality it is impossible for investors to borrow at the risk-free rate because the risk associated with individual investors is much higher than that associated with the Government.
We also know that the CAPM assumes that there are zero“risk securities of various maturities and enough quantities to allow for portfolio risk adjustments. But for example, Treasury bills have various risks (reinvestment risk, inflation risk or currency risk).
Theoretically, homogenous investors in market equilibrium have access to and use identical information and behave identically with regards to risk in portfolios. Everybody have the same information, and then will buy more good stocks and less bad stocks. For example, if investor A buys more of X than Y, then everyone will do the same and focus of X. Investors are assumed to valuate information the same way through the same articles and newspapers, and consequently they reach the same conclusions. According to William Sharpe, all investors have the same beliefs about expected returns, investment strategies and risks of available investments as long as they stay risk-averters. However, in real life, investors may have different opinions, ri
