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Forget CAPM Beta?

Posted in Big Ideas, Equity Premium

Does the Capital Asset Pricing Model (CAPM) make predictions useful to investors? In his October 2014 paper entitled “CAPM: an Absurd Model”, Pablo Fernandez argues that the assumptions and predictions of CAPM have no basis in the real world. A key implication of CAPM for investors is that an asset’s expected return relates positively to its expected beta (regression coefficient relative to the expected market risk premium). Based on a survey of related research, he concludes that:

  • The seminal research of Fama and French finds that the correlation between returns and betas of U.S. stocks is very small during 1963-1990.
  • Estimating stock betas using historical data is problematic because results can be unstable over even short periods and depend materially on:
    • The stock index used to calculate market returns.
    • The historical interval (one year, three years, five years…) used in the regression to derive betas.
    • The sampling frequency (daily, monthly, yearly,…) used to calculate stock and market returns.
  • Accordingly, there are large differences among beta data providers, as found in a recent survey of 16 websites and databases for the beta ranges of Coca Cola (0.31 to 0.80), Walt Disney (0.72 to 1.39) and Wal-Mart (0.13 to 0.71).
  • Industry-level betas are also unstable. On average across industries, maximum estimated beta is 2.7 times minimum beta.
  • The relative magnitude of betas often makes little sense. Estimated betas of arguably high-risk firms are often lower than those of arguably low-risk firms, suggesting that each investor should apply common sense and good judgment about a company, its industry and its national economy to estimate its riskiness (see the example below).

The following table, taken from the paper, illustrates one way to construct a “common sense beta” that considers and weights a menu of 11 firm risks on a five-point judgmental scale to construct a qualitative “beta” that summarizes stock riskiness. The five-point scale and final 0.5 multiplier are arbitrary, such that resulting “betas” are useful only for comparison of stocks.

qualitative-stock-beta-estimation

In summary, evidence from the body of research indicates that CAPM beta is not a useful tool for investors.

Cautions regarding conclusions include:

  • The paper offers no analysis relating qualitative “betas” to future stock returns. These “betas” may be no more useful in predicting stock returns than CAPM betas.
  • Snooping of choices available (market proxy, beta calculation interval, sampling frequency) in estimating stock betas and the expected market return may produce evidence in support of CAPM.
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