Is Traditional Beta Dead?
The Capital Asset Pricing Model (CAPM) won Stanford economist Bill Sharpe a Nobel prize. This is the culmination of modern portfolio theory that began with the Marcowicz’s mean- variance portfolio. CAPM says that investors should only be concerned with matching the return of a proxy for the market portfolio.
Mean variance theory says you can set up a diversified portfolio and get rid of a lot of risk — this make some sense but…
CAPM is wacky because it’s based on the idea that everybody knows exactly what’s going on and that simply is not true.
The S&P 500 is the benchmark for CAPM but critics have suggested that all tradable assets should be included. There’s a way you can do this through something called the Gone Fishin Portfolio — I’ll explain below — that is an improvement over market portfolio proxies based on a single large stock index.
The Three Factor Model
But there are still problems.
Efficient market theorists were hindered by two high returning “anomalies.”
The first is firm size where companies with smaller capitalizations have been shown to consistently outperform large companies. The second major market efficiency anomaly is that companies with high book-to-market values also consistently outperform the market.
The battle raged as efficiency academics struggled to disprove these high yield anomalies. They fought to prove these efficiency bashing results wrong until finally…
They Gave Up
When they realized they couldn’t just explain them away they developed a new theory — to account for the anomalies of the “small firm effect” and “value” investing. That theory is the three- factor model.
This new model cued in on (1) value, (2) size, and (3) a proxy for the return of the market.
In this framework, the average small stock is seen as riskier than the average large stock.
Accordingly, investors demand compensation for higher risk. Because of this, small stocks — where new products and innovators incubate — tend to earn a higher return than large stocks.
It explains why small caps do well in almost every market environment, and why Lou Basanese’s White Cap Index posts such high returns.
But in that same small cap universe there are numerous small companies that are little because they are soon to fail. In this view large capitalization companies are seen as established in their industry and less likely to go bankrupt than their smaller counterparts.
The three-factor model…
says that a portion of the higher return reflects the premium for risk that investors demand over less risky large stocks.
Unfortunately, the rub here is that investors consistently expect large-value stocks to outperform small-growth stocks — statistically it’s not going to happen.
Then a flood of academic papers rolled in documenting many more high returning anomalies ranging from newly issued stocks to international equities with inexplicably high returns from an efficiency perspective. Cutting edge finance researchers realized that a whole new market paradigm was needed where beta is not fully linked to the market proxy but to individual investor behavior.
Human behavior is not mathematically precise since it’s often based on fuzzy thinking and psychological quirks.
It all starts with education,
– Doc Brown
BIO: Doc Brown is a national expert on the stock market. His courses “How to Make a Million Dollar Portfolio from Scratch” at the Oxford Club is a national bestseller. Dr. Brown’s research appears in some of the most prestigious academic journals in the field of finance. See Journal of Financial Research and Financial Management. Scott is an associate professor of finance in the Graduate School of Business at the University of Puerto Rico.
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