Security Analysis and Portfolio Management - Essay Example

On the other hand, the intuition for the growth stocks that the stocks have higher prices in the market compared to their book value creates the definition. These findings were made when the two scholars Fama and French tested the leverages, book market ratios and price earnings ratios among others in an effort to examine the Capital Asset Pricing Module. 2. Factors explaining stock returns. The Capital Asset Pricing Model is a method published in 1992 and that has been popular in portfolio management.

Analysis has brought it to question since the model does not satisfy the questions of stock management entirely (Yue et al 2006). The limitations of CAPM lie in the assumption that investors need measure only a single risk that will determine the sensitivity of market returns. The model required to be efficient is therefore supposed to address a number of factors that pose as a risk to security management (Fama and French). The measures should address sensitivity of the market returns by distinguishing small stock risks over risks posed by larger stocks.

The new measures implemented by Fama and French have proved to be efficient in large stocks but have not been measured on the small stocks yet from lack of access to the data on security. The research by Fama and French is applicable in the international market as well as the local portfolios in the United States (Carson et al 1999). A market risk factor and a value risk factor provided are means to explain average returns in the stocks internationally (Cohen 1967). Measured by Fama and French, the returns on an international portfolio market of stocks provide the measure of the market risk factor while the difference in the returns on the high book to market and low book to market measures the value risk factor (Case 2011).

The CAPM limitations lay in the assumptions that every investor is rational in his expectations , there is a normal distribution of returns, the production and financial sectors are separated, quantity of assets is fixed, the capital market is of perfect efficiency and the risk free rates of borrowing and lending are equal (Bossaerts 2002). These assumptions among others greatly counter the realities of the markets and security and provide erroneous conclusions that create the impression that the state of the portfolios is of high standard when it is not (Fischer 1979).

According to French and Fama the idea of Capital Asset Pricing Model creates a system that oversimplifies the entire process of security analysis while leaving out vital steps that create large assumptions in the long run. For example, the distribution of returns argues that all investors see the same opportunities; the model assumes the risks created by other factors on the investor while making his decisions to invest therefore ends up overlooking those risks (Case 2011). The argument of the CAPM lacks any link to the situation of real life events and practicality.

The major assumptions made overlook the important aspects of the markets rather than create a weighted concern for it and the details of stocks. Since theories and models are not necessarily perfect, the overlooked matters should address the less sensitive situations that would cause much less damage or none on the investors in the end and not the other