The Impact of Investor’s Irrational Decisions on the Validity of the CAPM Model

Abstract

In traditional finance theory, the Capital Asset Pricing Model (CAPM) has long been the dominant theory for asset valuation. However, the exist and prevalent of the irrational investment behaviors in real-world markets lead to deviations between the CAPM predicted prices and actual asset prices, which raising doubts about the accuracy of the CAPM. To solve this contradiction, Behavioral finance challenges the Hypothesis of Rational Man and the Efficient Markets Hypothesis by studying markets existing anomalies, thereby figure out the flaw of the CAPM. This paper will summarize and explain the previous research. Then explore how irrational investor decisions undermine its validity by employs behavioral finance theories—such as Prospect Theory, Mental Accounting, Cognitive Biases and others—to analyze the limitations of the CAPM through casual logic chain. The paper’s findings suggest that investors should be watchful about the emotional biases and cognitive errors to reduce investment losses caused by irrational factors.