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Pricing an Asset
If there should be a momentary disequilibrium such that the priceof an asset were "too high," causing expected returns to be "too low,"investors would sell the asset and its price would return to the equilibrium level. And, the converse would be true for assets whose prices were "too low" and whose expected returns were consequently "toohigh."The attractions of a religion based upon faith in Sharpe's modelare obvious. There is absolutely an understandable predisposition to be a "believer."
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Yet one is obviously naturally deterred initially by the lack of realismof the assumptions underlying the model. There are two ways to assessthe practical implications of this lack of realism. One is to examinethe assumptions themselves to see whether their apparent absurdityor lack of realism is as great as seems true at first glance. Anotherapproach is to ignore the realism of the assumptions and to see whetherpredictions based upon the model are confirmed by experience. Fortunately, it is now generally understood that the value of a modellies in its predictive or explanatory power and that the model cannotbe judged by reference to the realism of its underlying assumptions.This point has been expressed with great clarity and persuasivenessby Milton Friedman in a famous essay:
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Therefore, we shall pause only briefly to comment on the realism ofthe underlying assumptions before passing to the more important taskof determining the explanatory or predictive power of the model.
