Final answer:
CAPM ignores the contingent nature of risk based on wealth, the opportunity cost of risk-free investments, idiosyncratic risk, the imperfect proxy of the market index, and differences in risk aversion among investors.
Step-by-step explanation:
One of the shortcomings of the CAPM (Capital Asset Pricing Model) is that it ignores the contingent nature of risk. CAPM assumes that all investors are equally concerned about upside and downside risks, regardless of their wealth or financial situation. However, in reality, individuals who are poorer may place a greater emphasis on downside risk, as the negative consequences of losing money may be more catastrophic for them.
Another shortcoming of CAPM is that it ignores the opportunity cost of risk-free investments. CAPM assumes that investors can freely access risk-free investments with no cost. However, in reality, there may be costs associated with accessing risk-free investments, such as transaction costs or administrative fees.
Additionally, CAPM does not take into account idiosyncratic risk, which refers to risk that is specific to individual assets or companies and cannot be diversified away. CAPM focuses primarily on systematic risk, which can be mitigated through diversification.
Furthermore, CAPM assumes that the market index is a perfect proxy for systematic risk factors. However, the market index may not perfectly capture all relevant systematic risk factors, leading to potential inaccuracies in the expected returns calculated by CAPM.
Lastly, CAPM does not explicitly consider investors' risk aversion, which is the degree to which individuals are willing to take on risk in exchange for higher returns. CAPM assumes that all investors have the same level of risk aversion, which may not hold true in reality.