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What This Nerd is Reading: X-CAPM – An Extrapolative Capital Asset Pricing Model

Just passing this paper along which I missed.  Noah Smith mentioned it yesterday on Twitter and it looks pretty interesting.  If any fellow nerds have thoughts feel free to use the comments…

X-CAPM: An Extrapolative Capital Asset Pricing Model

Nicholas Barberis, Robin Greenwood,
Lawrence Jin, and Andrei Shleifer

Yale University and Harvard University


Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns: they expect the stock market to
perform well (poorly) in the near future if it performed well (poorly) in the recent past. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by
extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns, but is also consistent with the survey evidence on investor expectations. This suggests that the survey evidence does not need to be seen as an inconvenient obstacle to understanding the stock market; on the contrary, it is consistent with the facts about prices and returns, and may be the key to understanding them.

Read it here.

  1. BillieJones

    Holy Academia. I think this new focus on behavioral finance is interesting, but ultimately, to my simple mind, it seems futile to try to create a formula that accurately predicts human behavior.

    I have the same criticism about this paper that Cullen has about Friedman’s work……there are way too many qualifiers required to make the “formula” work. for example, infinite timelines, a set number of potential options (paths) available to rational actors etc. It’s just not realistic.

    It seems that after all of that hypothesizing and whittling down of factors that may negatively affect the formula; we are left with this conclusion: the “rational” investors were more careful about their assumptions while the “extrapolators” folly was a common finance 101 mistake…….drag the cash flows at a constant growth rate across.

    I don’t mean to sound like a hater, the authors are clearly brilliant, but they could have asked any old school CFO their take on this and saved themselves hours of math. Assumptions: “Garbage in, garbage out”

  2. Cullen Roche

    Hi Billie,

    Smart comment. I don’t have much first hand experience with the use of pricing models on the primary markets. What’s your experience with how this is done and how applicable models like CAPM actually are? My experience is that they’re a very general guide that influences corporate decision making, but certainly doesn’t play the same role that some academic economists might like to think.



  3. Cullen Roche

    Money multiplier, inflation necessarily hurts our living standards, etc. It’s a miracle that this man is so fabulously successful in private equity and payment systems when he clearly knows nothing about macroeconomics and economics in general….He did blow up his hedge fund, but I guess people don’t care about that.

  4. alhick

    “The model includes both rational investors and price extrapolators, and examines security prices when both types are active in the market. Moreover, it is a consumption-based aset pricing model with infinitely lived consumers optimizing their decisions in light of their beliefs and market prices. As such, it can be directly compared to some of the existing research.”

    So in order explore evidence that investors do not behave like rational actors should in an efficient market, they use a general equilibrium model with agents who have rational expectations and infinite foresight. This is not a paper that is going to tell us anything about the real world.

  5. BillieJones


    I just view DCF as a tool. Most people I know prefer IRR/MIRR because its easier to quickly evaluate opportunity cost, but most models I have seen also have a NPV or APV (CAPM) component, because it doesn’t take much extra effort to include it in your spreadsheet.

    As far as how applicable DCF is, I think it just depends on the investment opportunity type. With private businesses that have established cash flows; DCF is very useful, same goes with income producing real estate. Ive looked at a few Private placement “Angel investor” type start-ups, and I’ve noticed that it isn’t as common in that circle although admittedly, I’m not very deep in that area. For obvious reasons, DCF analysis becomes a crapshoot when a company is pre-revenue.

    It seems that the issue people have with DCF is that they want it to be a “magic 8 ball” of sorts, where they input a set of ingredients and out comes a perfectly accurate valuation. The truth, is that its just a tool…..an incredibly valuable one IMO, but it will only output what you put in. Quality assumptions are vital. I always run multiple scenarios with a variety of different assumptions to replicate potential different economic environments. I view my DCF model (MIRR, NPV) as a sort of dashboard that just tells me what an opportunity might look like under different sets of conditions.

    I’m always looking for a better, more efficient way to evaluate investments, but so far DCF is one of the better tools I have found. I’m all ears if anyone has a method that they prefer.

  6. Frederick

    Yes, like CAPM, it’s a classroom gadget. Nothing more. CAPM is a guide for CFOs, but not a rule.

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