Investing on the CAPM Pricing Error

Abstract

We tested an investment strategy based on the pricing error of the CAPM model. Starting with the Markowitz (1952) [1] methodology, we replaced the standard expected returns vector with the expected errors vector from the CAPM model, assuming that such errors are nonzero and persist over time. When evaluated over the entire examined period, all of the resulting portfolios outperformed the market portfolio. Except for some shorter periods, our hypothesis was fully confirmed. That is, the performance of our alpha portfolios was significantly better than the market portfolio. In other words, the pricing error of the CAPM model seems to be nonzero and to have an inertial component.