Academic Attack 2: Beta Is a Fickle Short-Term Performer

Academic Attack 2: Beta Is a Fickle Short-Term Performer (and Sometimes It Fails to Work for a Full Decade)

The divergence of theory from evidence is even more striking in the short run: For some short periods, it may happen that risk and return are negatively related. In 1972, for example, which was an “up” market year, it turned out that safer )lower-beta) stocks went up more than the more volatile securities. Fortune magazine commented dryly on this well-publicized failure, “the results defied the textboos.” What happened was that in 1972 styles changed in Wall Street as institutional investors eschewed younger, more speculative companies, the “faded ladies” of the late 1960s, and became much more enamored of the highest-quality, most stable leading corporations in the so-called “first tier” of stocks. This was the Nifty Fifty craze. It became clear that beta could not be used to guarantee investors a predictable performance over a period of a few months or even a year.

Black, Jensen, and Scholes found a similar type of anomaly for the entire period from April 1957 through December 1965. Not only does the zero-beta return exceed the riskless rate, but during this period of nearly nine years, securities with higher risk produced lower returns than less-risky (lower-beta) securities. Substantial deviations from the relationship predicted by the CAPM were also found for many subperiods.

The experience of the 1980s provided even more dramatic evidence of the folly of relying on beta measures to predict realized rates of return. It turned out that for the entire decade of the 1980s realized mutual-fund returns bore no relationship to their beta measures of risk.

A fickle short-term performer. Photo by Elena

The following chart shows the relationship between mutual-fund returns during the 1980s and the beta measures of systematic risk. These are the same funds which displayed a positive relationship between realized returns and risk  covering a much longer twenty-year time period. Note that there is no positive relationship between the beta risk measures and the mutual-fund returns (the correlation coefficient between betas and returns for the 1980s is essentially zero). Indeed, were it not for the one observation in the top right-hand corner of the graph, there would have been a tendency for high-beta portfolios to earn a lower rate of return (That fund in the top right-hand corner of the chart with the extraordinary record is the Magellan Fund).

Thus, investors who thought they could use the capital-asset pricing model to fashion higher-risk portfolios in order to achieve higher rates of return during the 1980s were sadly disappointed.

If we mention that beta summarizes the total systematic risk of securities, we must accept three uncomfortable conclusions: 1) In some short periods, investors may be penalized for taking on more risk; 2) in the long run, investors are not rewarded enough for high risk and are overcompensated fory buying securities with low risk; and 3) in all periods, some unsystematic risk is being valued by the market. Any of these results is a serious contradiction of the CAPM.