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Be Careful With Your Low Beta Bets

Be Careful With Your Low Beta Bets

Petri Jylha, Imperial College

Matti Suominen, Aalto University

Tuomas Tomunen, Columbia University

Betting against beta

All MBAs and Finance students learn in their basic finance courses the Capital Asset Pricing Model (CAPM), a celebrated theory largely attributable to the Nobel price winner William Sharpe. This theory states that riskier assets in equilibrium should earn higher returns, and that the relevant measure for a stock’s risk should be its “beta,” a measure of the stock’s systematic risk. Technically a stock’s beta equals its correlation with the stock market index, scaled by the ratio of its volatility to the market index volatility.

All well in theory, but in practice the CAPM has failed miserably. In the real life the stocks with the higher risk measures, i.e., the high beta stocks, have over the recent decades systematically earned lower returns than the low beta stocks. In fact, investing in low beta stocks has become a highly popular investment strategy in the financial market, one that is today aggressively marketed to all major institutional investors.

Be careful: Betas do not measure what you think they measure!

In a recent working paper “Beta Bubbles,” we suggest a potential reason why the logically well motivated CAPM fails to work in...