Lion of the Blogosphere

Capital Asset Pricing Model and libertarianism

To quote Wikipedia:

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk. The model takes into account the asset’s sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM “suggests that an investor’s cost of equity capital is determined by beta.”

The CAPM was invented in the 1960s, and became popular among finance people in the 1970s. It was taught in the most basic corporate finance class when I was a college student at Penn in the 1980s. It’s a fine model for valuing stocks and bonds, but what does it have to do with libertarianism?

Libertarians take it as a matter of faith that the amount of money someone earns is exactly equal to the value they create, but they have a tough time explaining exactly why some people earn such massively more money than other people. Thus they picked up on the part of the CAPM which states that more non-diversifiable risk equals higher returns, chose to ignore the “non-diversifiable” part, and applied to this to every rich person. So why is Bill Gates so rich? Because he took more risk. Why is Warren Buffett so rich? Because he took more risk. If you only stopped being lazy and took more risk, you too would be rich!

Carly Fiorina is considered one of the worst CEOs ever, yet she walked away from HP with approximately $200 million more than when she walked in. How was that risky? The regular employees of HP had much riskier jobs, because approximately 30,000 of them were laid off during Carly’s tenure, and they walked away with not much money at all.

Because entrepreneurial risk is mostly diversifiable and not correlated with systemic risk, the CAPM actually teaches us that there would be no return for such risk. And, of course, CEOs and other high-level corporate executives don’t take any risk at all. The higher your job level in corporate America, the all-around better and less risky your job is.

Regarding entrepreneurial risk, because people tend to have an optimism bias and the longshot bias , it’s more likely than not that people are taking too much risk rather than not enough risk. Entrepreneurial risk may be like the risk of the roulette wheel, where 38 people go in and one person wins 35 times their investment while the other 37 lose. (It should be noted that people play roulette despite the fact that it’s known to be rigged in favor of the house, and the same with the massively more popular lottery, but people have an optimism bias and a longshot bias.)

Written by Lion of the Blogosphere

October 27, 2015 at 9:18 AM

Posted in Economics, Investments

48 Responses

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  1. “Because entrepreneurial risk is mostly diversifiable and not correlated with systemic risk”

    I doubt it. Many startups have big corporate clients, and valuations for startups are at least partially tied to how much they could make if they were acquired by big tech companies. Thus I would imagine that their valuations are pretty high correlated with other tech startups.

    I think the more interesting issue is that the size of the full joint distribution specifying the dependence between all assets is extremely large, so simple empirical estimators are insufficient. For example, what is the likelihood of Apple going down tomorrow given IBM went up and Google went down. There just isn’t enough data.

    I dunno what the solution is.


    October 27, 2015 at 9:36 AM

  2. Nah.

    I think most libertarians simply notice with Mike Royko (if a bit more consistently) that battle does not always go to the strong, the race to the swift, love to the lovable, health to the wholesome, or wealth to the wise…

    …but that sure is the way to bet.


    October 27, 2015 at 10:07 AM

    • Mike Royko sounding exactly like Damon Runyon!


      October 27, 2015 at 2:28 PM

    • Rather than measuring the swiftest runner and predicting him to win the race, libertarians see who won the race and declare him the swiftest!


      October 27, 2015 at 7:37 PM

    • Mike Royko hasn’t noticed much in the last 18 years.


      October 31, 2015 at 2:56 AM

  3. I love this blog, but this is simply another very weak straw man attack on libertarians. Libertarians are the first to point out that other factors, such as using the government to keep out competitors, results in certain companies and individuals earning far more than average. Lion, you are way smarter and better than this, and I mean that in the best way possible. The collectivists created this monstrosity we call our government and libertarians recognize it is not even close to a free market.


    October 27, 2015 at 12:04 PM

  4. As a lapsed libertarian of sorts, I can’t say I’ve heard of that one.

    The last paragraph reminds me of an old stock newsletter favorite. Start with, say, 65536 leads and send half of them a letter that stock A will go up next week, and the other half that it will go down. Each week, send a new pair of letters to those leads where your previous guess was correct. After a few weeks, your remaining few subscribers will believe you are a stock picking god and you can offer to manage their money for a modest fee.


    October 27, 2015 at 12:50 PM

  5. “Entrepreneurial risk may be like the risk of the roulette wheel, where 38 people go in and one person wins 35 times their investment while the other 37 lose.”

    So you think it’s purely random eh? The only reason people are more successful is they got lucky at the casino of life? haha


    October 27, 2015 at 2:09 PM

  6. I think you go off-track here:

    “Libertarians take it as a matter of faith that the amount of money someone earns is exactly equal to the value they create,…”

    If people willingly pay you for a product (this product could be your labor) then their expectation is that the value they get will be higher than what they pay. Otherwise they would not make the deal in the first place. What complicates the picture is that most transactions are not personal: My manager does not pay me out of her pocket, many (if not most) purchases of goods and services are by organizations. I’m not sure if this makes the buying more or less analytical–professional buyers that I deal with seem much more formidable than individual buyers.


    October 27, 2015 at 2:33 PM

  7. If you really want to attack libertarians then go after Paul Ryan. I’d even help you!


    October 27, 2015 at 3:11 PM

    • Paul Ryan isn’t a libertarian.


      October 28, 2015 at 5:41 AM

      • Kinda. Sorta. Maybe… With the exception of Paul, he’s the closest thing to it in Washington.


        October 28, 2015 at 4:10 PM

  8. @Lion:
    You should look into Eric Falkenstein’s blog. He stopped blogging, it seems. But he shows that the risk premium is zero across most asset classes and most definitions of risk. Value at risk is a myth. Low risk/volatility assets actually have a slightly higher return. (Not enough that an individual investor can do much with this information though).

    His take is that investors don’t maximize absolute value over the long run with boring assets. Rather they want to maintain relative status. So they choose investments that are highly correlated with the market in general. People prefer to live through boom and bust cycles together with their neighbors. They don’t want to be left behind in a boom with boring assets even if those assets would be more resilient during busts and thus better in the long run. Their neighbors lose during busts too after all, so their status is maintained.

    However the CAPM is not the primary argument libertarians use to justify the high incomes of the CEOs they worship. Rather they use the labor theory of value. They don’t claim that Carly Fiorina was compensated for risk taking. Rather she increased the value of HP on the margin by more than what she was payed. Thomas Sowell, the disciple of Milton Friedman and favorite contemporary economist among libertarians, teaches endlessly that prudent shareholders have agreed to pay her this much after careful deliberation. They chose the best of available alternatives. It is their wealth at stake after all.

    This is nonsense for all kinds of reasons, but it even omits all of those who chose not to buy HP stocks precisely because they didn’t think that Fiorina was competent. There is a widespread notion among libertarians that only those who participate in a transaction have a right to pass judgement. This is also how they justify proles buying unpalatable food and ill-fitting clothes. There should be a name for this fallacy that does not even follow from libertarian philosophy. It does reveal something about the underlying psychological biases of libertarians.


    October 27, 2015 at 3:42 PM

    • That’s surprising to hear about Sowell. In his book BASIC ECONOMICS, he argues that it’s actually incredibly difficult to calculate the marginal product of labor, and gives the example of Roger Maris hitting 61 home runs (but helped by Mickey Mantle batting after him in the line-up). Obviously, if the hitter after Maris were complete crap, then pitchers could walk Maris, but that wasn’t an option since Mantle was an even more feared opponent. I always wondered if the sabermetrics boys had devised a way to isolate Maris’ “true value.”

      Not that it seemed to concern Sowell. Libertarians do not need to argue the market distributes compensation perfectly. Instead they can maintain it’s a superior outcome compared to government interference.

      Smarter libertarians should take the same approach to dealing with tragedies of the commons, natural monopolies, and externalities. Instead they seem inclined to hand-waive the problems away.


      October 27, 2015 at 11:43 PM

      • Thomas Sowell -Penny-Wise Politics

        “Politically imposed limits on the pay of CEOs is one of the most penny-wise and pound-foolish things that can be done. The difference between a top-notch CEO and a second-rate CEO can be billions of dollars on the bottom line. That is what drives up the pay of CEOs. If you want someone who will be top-notch in running organizations as huge and complex as Fannie Mae or Freddie Mac, there is no point offering $5 million a year if similar enterprises elsewhere are paying $20 million for people with the kind of ability required. Who is going to take a $15 million pay cut to go run these enterprises, in addition to having to put up with politicians? The money that can be saved by limiting CEO pay is chump change compared to the money that can be lost because you cannot attract top-notch talent.”

        Thomas Sowell – The ‘Greed’ Fallacy
        “If people who are capable of being outstanding executives were a dime a dozen, nobody would pay eleven cents a dozen for them.

        Many observers who say that they cannot understand how anyone can be worth $100 million a year do not realize that it is not necessary that they understand it, since it is not their money.
        All of us have thousands of things happening around us that we do not understand.”

        “One of the reasons why central planning sounds so good, but has failed so badly that even socialist and communist governments finally abandoned the idea by the end of the 20th century, is that nobody knows enough to second guess everybody else.”

        In short: Central Planners thought that they could know everything. They didn’t. Therefore though shalt not question the wisdom and merit of Central Executive Officers.


        October 28, 2015 at 12:16 PM

      • “The difference between a top-notch CEO and a second-rate CEO can be billions of dollars on the bottom line.”

        The standard libertarian explanation, but not proven by actual evidence.

        Lion of the Blogosphere

        October 28, 2015 at 1:42 PM

      • If ceo skill was so rare and correlated with salaries,

        Then why hasn’t japan collapsed yet?

        According to libertarians all the super rare people with magical ceo skills would have left for better paying positions elsewhere.

        The ceo of Toyota only makes 2 million per year!


        October 28, 2015 at 2:22 PM

  9. okay, how about a book of your essays, a “best of”.

    you can divide it up into sections:

    1. is that prole?
    2. NAMs in america
    3. the libertarian bible
    4. psycho killers
    5. the gays won
    6. the world’s tallest residential building (photos)

    i will design the book cover.


    October 27, 2015 at 4:41 PM

  10. People (and not just libertarians) tend also to forget that the government also provides the lion’s share of seed capital and resources behind most new technologies, the profits from which are then privatized by corporations. One of the reasons Henry Ford was such a proponent of Stalinist Communism (and also an ardent anti-Semite) was that he felt “industry would advance” faster if permitted to borrow at the same rates as government, and naturally his Jewish bankers (and probably others as well) couldn’t be convinced to lend at such rates!

    Viscount Douchenozzlé

    October 27, 2015 at 5:23 PM

  11. Libertarians take it as a matter of faith that the amount of money someone earns is exactly equal to the value they create, but they have a tough time explaining exactly why some people earn such massively more money than other people.

    Dey stole it fair’n square’n.

    Carly Fiorina is considered one of the worst CEOs ever, yet she walked away from HP with approximately $200 million more than when she walked in. How was that risky? The regular employees of HP had much riskier jobs, because approximately 30,000 of them were laid off during Carly’s tenure, and they walked away with not much money at all.

    Her laid off employees were all evil men and women, they deserved to have their children starved. You should be thanking Fiorina for such judiciousness. Rather curious you aren’t.

    The Undiscovered Jew

    October 27, 2015 at 6:08 PM

    • I realy don’t understand this. If your job evaporates, it’s your problem. Why people are acting like they are entitled to their jobs? This isn’t USSR. Thus is free enterprise and capitalism. It up to you to figure out how to make a living. Let’s sat Fiorina was a terrible CEO, so? This is life and some CEOs are no good and workers lose their jobs. I can’t stand all this whining. Like I always say: producers produce and complainers complain.


      October 27, 2015 at 8:33 PM

      • >I realy don’t understand this. If your job evaporates, it’s your problem. Why people are acting like they are entitled to their jobs

        Vulture capitalism is free enterprise.

        As an example look at Bain capital and mitt romney, who destroyed legitimate companies for greed and profit.

        Bain capitals business scheme was to use Bain capital to borrow enough money to get over 51% of a company.

        Then use the company as collateral to borrow even more money.

        Pay your self huge consulting fees and high ceo compensation. Company goes bankrupt everybody loses their job.

        Romney and friends walk off with millions.

        Banks lose all the money lent to Dade behring.

        Dade behring employees lose jobs.

        But in yakovs world and libertarian land this is perfectly okay because they are just exercising their economic freedoms!


        October 28, 2015 at 2:38 PM

      • Importing millions of third world immigrants to work for low wages is also free enterprise and capitalism.


        October 28, 2015 at 7:16 PM

      • @Godslayer

        So what do you suggest should be done? I actually have no idea how Romney made his money. I don’t know if I’m a libertarian or not, but I just like colonial and early America and how things were then. Economics are above my head, I just need to make a $1000 a day clean and that’s it. Very simple. And people who refuse to work should be in forced labor and if they still refuse, they should be flogged and then shot. All this stuff you say Romney did is complicated, I don’t understand all this, but assuming it’s true, what can be done? If it’s my company, can’t I pay myself whatever I want? Surely America didn’t get to where it is by running companies into the ground?

        Anyway, I think that anyone who deliberately causes a loss of more that 10 years income to his fellow man should be shot. If Romney acted criminaly, he should be punished accordingly. So you tell me: was it criminal?


        October 28, 2015 at 8:05 PM

      • Bain Capital bought failing companies and turned them around. In order to do this they had to shut down the parts that were losing money and lay off some of the workers. If they hadn’t done it the companies would have gone under and everyone would have lost their jobs. Think of it in terms of a doctor amputating a leg that has gangrene in order to save a patient’s life.


        October 28, 2015 at 8:45 PM

      • Explain dade then.

        Dade was profitable before it was bought by bain!

        Bain bought out dade in 1997

        Dade went bankrupt in 2002!

        Bain lost all of its shares during bankruptcy!

        After bankruptcy dade worked out a deal with new creditors and got a new ceo!

        The new ceo + dade worked their asses off to pay off their debt incurred by mitt romney and friends

        In 2007 dade was purchased by siemens for 6.7 billion!

        Keep in mind in the 5 years under bain control, bain sucked out a lot of money from dade and dade collapsed in 2002 1.5 billion in debt with no way to make interest payments. Bain also made a lot more money compared to the money lost purchasing the company and losing their shares.

        Mitt romney improving dade was the big lie that he spouted during his run for presidency.

        He took a profitable company and killed it to unjustly enrich himself.

        *source I have engineering buddies that still work for dade/siemens


        October 29, 2015 at 10:18 AM

      • @destructure:
        “Think of it in terms of a doctor amputating a leg that has gangrene in order to save a patient’s life.”

        Ever heard of organ theft? That’s what Bain capital is accused of. Killing a patient in order to extract valuable organs.


        October 29, 2015 at 4:22 PM

      • Around the 2012 election there was some left-wing viral video against Romney that went into detail on Bain Capital’s purchase of “SCM” and subsequent dismemberment of the company and layoffs in the mid-’90s, etc. What they failed to mention was that “SCM” was actually Smith-Corona Manufacturing, a typewriter company! That’s right – the dems made a propaganda video against Romney trying to attribute the demise of a typewriter company in the mid-’90s to vulture capitalists!

        On the other hand, Carly Fiorina is an idiot – she paid way too much for Compaq, which basically was a mostly non-differentiated hardware manufacturer, and when she did, thousands of people lost their jobs. She has no business anywhere near the controls of the world’s largest economy, and that is the difference between Mitt Romney and basically all of the other alleged “businessmen” vying for the Presidency – Mitt actually knows what he’s doing and has proven it thousands of times over.

        Viscount Douchenozzlé

        October 29, 2015 at 6:44 PM

      • If society expects me not to steal and murder then it has best provide me reasonable avenues of employment. Likewise, if you wish to believe in constructs like right to life or protected ownership of personal property, then it is also in your best interest to find jobs for the masses.


        November 3, 2015 at 3:54 PM

    • I realy don’t understand this. If your job evaporates, it’s your problem. Why people are acting like they are entitled to their jobs?

      In truth most everyone HP laid off soon after found equivalent jobs at other companies. But it makes no difference: Lion knows Fiorina is wealthier than he is, and damnation if he won’t make her pay for it.

      The Undiscovered Jew

      October 27, 2015 at 11:44 PM

  12. Speaking of Carly Fiorina, she’s been awfully quiet since the last debate hasn’t she? Just dropped off the face of the earth. It seems like Trump says something outrageous every day, and Carson comes up with some’d think Fiorina would maintain a little more visibility.

    Mrs Stitch

    October 27, 2015 at 6:40 PM

    • It’s all rigged. The establishment thinks that Carson will have a better chance of knocking off Trump than Fiorina.


      October 27, 2015 at 8:13 PM

    • She is running for VP. If there is an independent candidate she has 2 shots at it just this election cycle.

      howitzer daniel

      October 27, 2015 at 8:26 PM

    • Carson will fall back to second sooner than Bernie Sanders – who I also predicted would lose to Hillary – has.

      The Undiscovered Jew

      October 27, 2015 at 11:46 PM

  13. Libertarians believe value is subjective and that no objective measure of value or worth other than that of the parties directly involved in an economic exchange can possibly be admitted. So in their view Carly Fiorina still created the wealth she walked away with — the board that hired her, acting in accordance with the shareholders, valued her *potential success* at the price they paid. They paid for their expectations because they had the desire to see if those expectations would be realized, and that’s the value they exchanged with her.

    Of course we should all understand the absurdity of conflating executives of larges organizations with entrepreneurs! Corporate executives just use the monopoly and existing organizational powers of their firm and the labor of the thousands of people working under them to siphon off a piece of the value created by those who actually worked to make it!


    October 27, 2015 at 7:15 PM

  14. Let’s face it: America is a corporate Fascist state.

    To be a worker/employee/middle-class is the greatest risk of all. There is no one to advocate for the mass of people who actually do the work. Not the corporation, not HR, not the unions, not the Supreme Court, NOBODY. The table has been completely tilted to interest of the corporation both privately and publicly. We no longer have class conflict (which is healthy for a balance of power); we have utter class domination.

    The most inspiring story I’ve seen recently was how the French Airline workers mauled the executives who were going to cut their jobs. The American worker has been so beaten-down (from above and below) that he doesn’t have anywhere near the balls to ever fight back against the naked aggression against him. Like a sad sack, he just goes home and rationalizes how his emasculation was justified because of capitalism or something.

    Economic protectionism and strong unions is the real America; not corporate America.


    October 27, 2015 at 7:27 PM

    • How can workers make a comeback? The American Empire must die. All that money that goes into maintaining the empire can go into the economy instead. Let China be the world police and bully 3rd worlders. Empire is a money pit and terrible for the common man.


      October 28, 2015 at 1:19 AM

  15. Most libertarians can’t understand CAPM, and most don’t want to. Libertarianism is broadly popular because losers want to blame someone for not turning out successful and the government is just the scapegoat.

    The “Collectivists” to libertarians is the same as “Da Man” to urban blacks.


    October 27, 2015 at 7:42 PM

    • Remember Joe the Plumber!

      Libertarians don’t see themselves as losers. Rather they perceive themselves as powerful and successful even though they are mostly middle class. The libertarian demand for tax cuts for the rich makes no sense from a rational self-interested point of view. The poor can’t pay taxes, so it’s either going to be the middle class or the rich who have to pay. Libertarians are trans-rich. They identify as rich people, hence their irrational tax policy preferences.


      October 28, 2015 at 2:04 AM

  16. CAPM is actually a flawed model. According to the model, higher-beta stocks are supposed to outperform lower beta ones (as in more risk = more reward). In reality, the opposite happens. See Erik Falkenstein on this:

    Dave Pinsen

    October 27, 2015 at 8:28 PM

  17. The Randians seem to suggest the moochers, second-handers and looters take, take, take even in a perfectly free market because they’d be condemned to living in mud huts were it not for the heroic men of industry.


    October 27, 2015 at 11:37 PM

  18. Or, you couid “break even” and perpetuate indefinitely?


    October 28, 2015 at 1:57 AM

  19. Libertarians would not use capm to justify ceo salaries instead they would insist that ceo’s have some magical skills that is inherently absent in most of the population. And that without this skill companies will instantly collapse if ran by someone without these magical skills.

    Hp laid off all those workers because of the market! Not because of fiorinas incompetence.

    Fiorina earned her 200 million! Even though hp lost money it was because of market forces! If a average Joe without magical ceo skills ran they would have suffered even more losses and laid off even more employees.

    They would defend bill Gates by claiming that Microsoft created a lot of value.


    October 28, 2015 at 9:50 AM

  20. lion, do you read mike cernovich? he also went from libertarian to alt-right.


    October 28, 2015 at 5:35 PM

  21. quora on what is alt-right:

    “A lot of alt-right commentary tends to be more easily defined in terms of what it opposes than what it supports. Its main subjects of scorn tend to be out-of-touch, left-wing elites in politics, business, academia, and the mainstream media who they believe to be actively ruining society through their aggressive embrace of feminist, multicultural, and post-modernist ideas”


    October 28, 2015 at 5:38 PM

  22. Libertarians cannot suddenly switch to a labor theory of value, if their whole system is otherwise based on a demand theory of value “everything is worth what the purchaser will pay for it”.
    I think the best argument that there is something deeply wrong with CEO compensation is historical: CEOs were, overall and on average, not doing worse jobs (or less work) in the 1950s or 1970s, at least not 20 times or so worse jobs than today. But their pay has skyrocketed since then (absolutely and especially in relation to average workers/middle management). This is obviously absurd on a labor theory of value (because 1965 COE and 2015 CEO are basically doing *the same* job/work hours/decisions etc.), also cannot depend simply on the general state of the economy etc. (because CEO pay ran away from average employee pay). So the game must be rigged in some respects.

    nomen nescio

    October 29, 2015 at 5:12 AM

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