Should You Bet Against Beta

In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another

This model was developed by William F. Sharpe (1990 Nobel Prize Winner in Economics) and John Lintner in 1960. The model attempts to capture market behavior. It is simple in concept and has real world applicability. The model is based on the promise that the systematic risk attached to a security is the same irrespective of any number by security in the portfolio. The total risk of the portfolio is reduced with increase in number of stocks as a result of decrease in the unsystematic risk distribution over number of stocks in portfolio.

The more efficient the capital market is, the more likely the market will find its highest risk adjusted return. The efficiency of the capital markets is the “glue” that bonds the present value of a firm’s net cash flows,

This provided support for the CAPM and the approach for beta as the only predictor for differences in expected return (Haugen, 1999, p.238-239).

There is great potential for large returns when investing in high-risk, aggressive shares, but there is no guarantee. As there are not many aggressive strategies that will work in every market, a maximum point could be selected that would lead to either the re-evaluation or liquidation of the investment when reached. Rubber Plc should also consider their investment time horizon– the longer the better when it comes to investing in aggressive shares. The preference for an extensive investment horizon is due to the fact that it will enable them to endure market fluctuations better. Since this type of investment is likely to be much more volatile, demanding more frequent alterations to adapt it to changing market condition, it requires a more active management rather than a conservative, buy-and-hold approach. The CAPM (Capital Asset Pricing Model) can be used by Rubber Plc to price the portfolio; it helps calculate risk and what type of return to be expected from the investment. The general idea behind the model is that investors should be compensated for their time value of money along with their risk. The model is described in this formula: expected return = risk free rate + Beta * (expected market return - risk free rate) If the aggressive shares have a beta of 1.5, for example, for every 10% increase in the market index return, the share return will increase by 15%. However, if the market return falls, then

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

JENSEN, M. C., BLACK, F. & SCHOLES, M. S. 1972. The capital asset pricing model: Some empirical tests.

Capital Asset Pricing Model(CAPM) is introduced by Sharpe, Lintner, and Mossin and this model is derived by Markowitz mean-variance model theory. CAPM is applied to investment decision problems. CAPM is also about the understanding of an assets return and also the diversify of risk.

This summary provides a brief overview of Capital Asset Pricing Model (CAPM) as an alternative method for estimating expected returns. This paper also discusses the positive and negative effects of CAPM along with the risks of Beta and why this model has its share of drawbacks and critics in the marketplace. The first section will cover the basics of CAPM including its flaws and rewards. Next, the risks of beta and the strengths and weaknesses are discussed in conjunction with its relevance to CAPM and why it’s important to investors who are willing to take greater risks. Finally, an application is provided to show how beta affects CAPM from a financial manager’s perspective.

There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)

Risk and return are the fundamental parameters of any investment. While some investments may present greater risk they are countered by a higher rate of return. The vice versa holds true as well, less risk corresponds to a lower return. One way to measure risk is through calculating the standard deviation of returns. This measurement tells an investor how volatile or risky an investment is, by providing the investor with a range of possible outcomes based on the stocks expected return. Therefore, the lower the standard deviation percentage the less risk a given investment has. Moreover, when risk is being analyzed for more than one investment in a portfolio, a correlation of returns measurement is used. This calculation determines whether or not the investments respond similarly (+1) or conversely to market changes (-1). The closer the correlation is to -1 the more diversified the investment is resulting in less risk (Hirt, Block & Basu, 2006). Combined, these measurements provide investors with the tools necessary to analyze an investments risk and determine the best investment choices.

In Conclusion, we have shown that low risk investing is useful for both selecting stocks within an industry and for selecting industries betting against Beta earns positive returns for both industry selection and inside industry stocks selection (Asness).

Since mutual fund has been a primary investment instrument in the U.S. financial market as well as other countries around the world. The valuation of mutual fund’s performance has been drawn enormous attention from both financial practitioners and academics. Financial models have been established and developed in the financial market and these models have the purpose of assessing the expected returns of stocks and evaluating their performance related to the exposure to the market. The exploration for the risk-related asset pricing model that clarifies variations in stock returns is one of the most important issues in finance. Apparently, the capital asset pricing model (CAPM), which is proposed by Sharpe (1964) and Lintner (1965), and the Fama and French three factors model, which is proposed by Fama and French (1992, 1993 and 1995), are relatively significant and conventional finance models. It has been almost fifty years since the CAPM was put forward.

The evidence gained from examination done by Nimal and Fernando (2013) concerning Tokyo Stock Exchange (TSE) and the Colombo Stock Exchange (CSE) confirmed not only that beta is a useful tool in expanding deviations in market premium, but also that there is a relation between return and beta. However, the previous research done in the Japanese market by Yonezawa and Hin, (1992) did not confirm the validity of the CAPM. In their research, they checked monthly returns from January 1952 to December 1986 and concluded that limited diversification was the main cause of CAPM failure.

The Capital Asset Pricing Model (“CAPM”) was introduced by Sharpe (1964), Lintner (1965) and Mossin (1966) to provide investor an understanding in relation to the expected returns of their investment. However, this theory has been criticised by some empirical models resulted from the unrealistic assumptions. This paper will critically analyse the limitation of the CAPM and will discuss Arbitrage Pricing Theory (“APT”) and Fama-French (“FF”) Three-Factor Model (“TFM”) as the possible alternative empirical approaches.