Arbitrage Pricing Theory and Multi-Factor Models › The Limitations of Single-Factor Models
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Before diving into APT, let's understand why we need something beyond CAPM. The single-factor model assumes that the market portfolio captures all systematic risk. Under this view, two stocks with the same beta should have identical expected returns, regardless of their other characteristics.
Empirical evidence tells a different story. Decades of research have documented persistent patterns that CAPM cannot explain:
- Size effect: Small-capitalization stocks have historically outperformed large-cap stocks, even after adjusting for their higher market betas
- Value premium: Stocks with high book-to-market ratios (value stocks) have earned higher returns than growth stocks with similar betas
- Momentum: Stocks that performed well over the past year tend to continue outperforming in the near term
- Profitability: More profitable firms earn higher returns than predicted by their market exposure alone
These anomalies suggest multiple sources of risk affect returns. A multi-factor framework better describes reality and provides more accurate risk assessment.