The Failure of CAPM, Compression of Risky Asset Spreads and Paths Back to Normalcy

The Failure of CAPM, Compression of Risky Asset Spreads and Paths Back to Normalcy

Harry Markowitz, one of the original founders of modern portfolio theory, recently explored in a simple yet elegant paper how the capital asset pricing model (CAPM) crumbles in the real world (Markowitz, 2006). A striking consequence of this paper, which he does not mention but is relevant for investors today, is that the increasing availability of leverage for some investors may actually drive all risky security prices higher, even those not held by levered investors, potentially leading to a market far from equilibrium and with an ultimately destabilizing outcome.

Fascinating article, can be read on the Pimco website