Gcapm (I): A Microeconomic Theory of Investments
40 Pages Posted: 26 Mar 2003
Date Written: March 16, 2003
Based on the invisible hand of the market, this paper proposes a general microeconomic theory of investments under the framework of neoclassical microeconomics. The theory requires minimum assumptions and allows investors to have time-variant and heterogeneous investment utilities and expectations. It prescribes a set of static and dynamic General Capital Asset Pricing (Theorems and) Models - collectively labeled as GCAPM. GCAPM unifies currently seemingly-conflicting modern finance theories and connects them more closely to real-world finance. GCAPM independently derives a set of new CAPM paradigms under its heterogeneous world and shows that Sharpe's CAPM paradigms are alive and well but were overzealously misinterpreted for decades. The most noticeable misinterpretation is the widely accepted CAPM beta risk premium hypothesis, which wrongfully asserts that holding higher-beta-risk assets should generate higher ex-post returns. GCAPM shows that, as far as beta risk is concerned, it is "prudent beta risk management" rather than "reckless beta risk taking" that produces higher ex-post returns. GCAPM's general equilibrium also supports Ross and Roll's APT, which has been criticized as an arbitrage-free hypothesis without supporting equilibrium theories. GCAPM shows that the quality of a capital market equilibrium is only as good as the quality of its member investors. It agrees with the nascent behavioral finance theory that investors' psychological weaknesses and cognitive biases can influence capital asset pricing. However, GCAPM shows that competitive capital markets share a common evolutionary force that will eliminate known irrational investment behavior over time and "mature" capital markets should mainly reflect investors' normative financial needs, investment objectives, risk tolerances, and best forecasts of future economic states.
Release Note: I had made substantial structural changes to the previous edition of GCAPM (I) paper. The static and dynamic cases of GCAPM are now thoroughly discussed in two separate Sections. A new Section, titled "The Quality of Capital Market and Behavioral Finance," is added to address the flaws of human investment behavior and capital markets' evolution forces. The old Section regarding canonical asset pricing is removed from the paper and will be published in a separate paper tilted "Canonical Asset pricing and Asset Allocation Theorems." Except for the misinterpreted beta risk premium hypothesis, whose empirical tests prematurely declared the death of CAPM, materials regarding other CAPM misinterpretations are removed and will be discussed in a separate paper titled "CAPM Paradoxes and their GCAPM Interpretations."
A 1997 version of this paper was titled: "General Capital Asset Pricing Model (GCAPM): A Complete Mathematical Appendix"
A 2001 version of this paper was titled: "General Capital Asset Pricing Models (GCAPM) - Part I: A Microeconomic Theory of Investments (Mathematical Edition)"
JEL Classification: D50, G12
Suggested Citation: Suggested Citation