To paraphrase Matt Taibi, speculators are like a giant vampire squid attached to the face of the financial markets. Speculators ignore the basic purpose of markets, facilitating wealth creation by enhancing the efficiency of capital allocation, and instead try to make short-term profits while being indifferent to underlying value creation. This hijacking of markets creates the bubbles and collapses that periodically make headlines, destroy people’s savings and impair society’s productivity in addressing human needs and wants. The problem with the Capital Asset Pricing Model is that it is at best a tool useful only for such speculation, though ironically it is not even very good at that. Social investment should reject CAPM and pursue tools that help finance realise its highest purpose: the creation of value.

CAPM relies on comparisons of the changes in a company’s share price to the changes of its peers in a given market over time. These comparisons produce a figure called “beta” that is intended to describe the risk of a given firm and assist in the diversification of a portfolio of investments. If we wish to use markets to create value, be they traditional or social investments, such a strategy is fatally flawed.

Critically, beta does not provide meaningful information about risk. Beta is calculated so that a stock that quickly lost value would appear to be more risky the day after it lost value, than the day before it lost value. Yet the day before, investors were in risk of imminent losses.

Since beta, even in that simplistic scenario, would be guiding us in the completely wrong direction, should we attempt to trust it in far more complicated scenarios of predicting losses?

In another thought experiment, imagine you were analyzing the miraculous communication technology of the 1970s and 80s -- the pager. While a highly successful sector for years, we also know that at some point in their trajectory the fortunes of pagers turned as cell phones began their rise to prominence. CAPM would most favourably price companies in the pager sector, based on historic data, exactly when when they were riskiest: when they had peaked and were about to decline. Like a fire department that comes 24 hours after it’s called, this service is totally useless.

Those fundamental flaws are sufficient reason to abandon CAPM, though the list of theoretical and applied problems is longer still. Suffice it to say that there are better models for social investment to import from traditional finance.

Social investors are trying to create financially sustainable organisations that accomplish more social good than any alternative use of their funds. In service of that mission, the theory of value investing, as created by Benjamin Graham and best exemplified by his student Warren Buffet, the most successful investor alive, provide the ideal blueprint.

Value investing emphasizes the hard work of thoroughly reading past and present financial statements, cultivating deep sector knowledge, working with top quality management you trust, building a margin of safety into investments by seeking great value at a given price, superior corporate governance, and other skills and practices that cannot be reduced to a spreadsheet.

The advantage of such a framework is that it places the emphasis in the same place social investments should: building value. And it works. Buffet’s investments have generated average annual returns of 20%, more than double the market average.

Financial markets create wealth by creating value, and have managed to do so despite the draining effects of speculators who siphon wealth without supporting value creation. It is a testament to the markets that they can continue to generate wealth despite these inefficiencies, as well as a tragedy that the continued abuse of their basic function threatens to undermine them and tarnish the reputation of good financial theory along with destructive financial theory like CAPM. For social investors to best realise their goals, they need to embrace the best of finance, and reject its worst.

Note: For the counter argument, see Alex Levin's Valuable or Vampire: Why Impact Investors Should Embrace the Capital Asset Pricing Model (CAPM). For a primer on the Capital Asset Pricing Model (CAPM), see Wikipedia and Investopedia.

Photo credit: http://www.flickr.com/photos/masochismtango/302815420/

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