William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). CAPM provided the first precise definition of risk and how it drives expected returns.
The CAPM looks at returns through a “one-factor” lens, meaning the risk and return of a portfolio is determined only by its exposure to beta—the measure of the equity-type risk of a stock, mutual fund or portfolio, relative to the risk of the overall market. CAPM was the finance world’s operating model for about 30 years. However, all models, by definition, are flawed or wrong. If they were perfectly correct, they would be laws, like we have in physics.
In 1993, Eugene Fama and Kenneth French proposed a new asset pricing model, which became known as the “Fama-French Three-Factor Model.” This model proposes that along with the market factor of beta, exposure to the factors of size and value explain the cross section of expected stock returns.
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