CAPM: A Tale of Two Versions

Given that categorization is the core of cognition, we argue that investors do not view firms in isolation. Rather, they view them within a framework of categories that represent prior knowledge. This involves sorting a given firm into a category and using categorization-induced inferences to form earnings and discount-rate expectations. If earnings-aspect is categorization-relevant, then earnings estimates are refined, whereas discount-rates are confounded with the category-exemplar. The opposite happens when discount-rates are categorization relevant. Earnings-focused approach, predominantly used by institutional investors, leads to a version of CAPM in which 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. Discount-rate focused approach, typically used by individual investors, leads to a second version in which the relationship is strongly positive with growth stocks doing better. 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. 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).