New Research Tries To Solve For Beta Risk’s “Failure” For Stocks

At the core of modern finance is the proposition that beta (market) risk is the dominant factor that drives performance. But numerous empirical tests of the capital asset pricing model (CAPM) over the decades suggest otherwise. There have be various attempts to adjust CAPM to find a closer mapping of risk and return, but the results have been mixed. Perhaps two new research papers move us closer to the elusive goal of revising a CAPM-based view of asset pricing so that its theoretical ideal for risk and return moves closer to empirical results in money management practice.

Before we briefly look at the research, let’s note that beta risk works much better in an asset allocation framework compared with using CAPM within asset classes. Plotting historical returns vs. beta for asset classes reveals a relatively robust relationship. The main challenge is within asset classes. In particular, many studies over the years demonstrate that the relationship between stocks and equity market risk overall is weak. In some research, beta risk appears to predict the opposite of what CAPM anticipates. That is, certain empirical studies show that low betas lead to high returns and vice versa–the basis for why so-called low-volatility strategies can outperform standard market-weighted portfolios.

Various efforts to refine the idea that higher risk does in fact relate to higher return for a basket of stocks has led to various modeling enhancements. The most famous is the Fama-French three-factor model that identifies beta risk in three flavors (market, valuation and capitalization) rather than the single factor market beta of CAPM.

As the years have passed, many innovations have been presented, delivering an ever-expanding suite of x-factor models. Two new and intriguing additions to the alternative methodologies introduce a so-called investor beta to the mix and a business-cycle variation of the Capital Asset Pricing Model.

Let’s start with the investor beta model. The idea of “Investor Betas” (Ryan Lewis and Shrihari Santosh at University of Colorado, Boulder) is a model that “implies that an asset’s expected return is linear in its average idiosyncratic beta with respect to each active investor’s portfolio return.”

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