CAPM: A Tale of Two Versions

Categorization is the mental operation by which brain classifies objects and events. We do not experience the world as a series of unique events. Rather, we make sense of our experiences within a framework of categories that represent prior knowledge. Given that categorization is the core of cognition, we argue that the traditional view that each firm is viewed in isolation needs to be altered. Instead, like every other object they ever come across, investors view each firm within a framework of categories that represent prior knowledge. This involves sorting a firm into a category based on a subset of firm-attributes. Such categorization-relevant attributes are refined whereas other firm-attributes are confounded with the category-exemplar. Two versions of CAPM arise as a result. In the first version, the relationship between average excess return and stock beta is flat (possibly negative). Value effect and size premium (controlling for quality) arise in this version. In the second version, the relationship is strongly positive. The two-version CAPM accounts for several recent empirical findings including fundamentally different intraday vs overnight behavior, as well as behavior on macroeconomic announcement days. The tug-of-war dynamics of the two versions also suggest that momentum is expected to be an overnight phenomenon, which is consistent with empirical findings. We argue that, perhaps, our best shot at observing classical CAPM in its full glory is a laboratory experiment with subjects who have difficulty categorizing (such as in autism spectrum disorders).