badbeta - Bad Beta, Good Beta John Y. Campbell and Tuomo...

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Bad Beta, Good Beta John Y. Campbell and Tuomo Vuolteenaho 1 First draft: August 2002 This draft: January 2003 1 Department of Economics, Littauer Center, Harvard University, Cambridge MA 02138, USA, and NBER. Email john_campbell@harvard.edu and t_vuolteenaho@harvard.edu. We would like to thank Michael Brennan, Randy Cohen, Robert Hodrick, Matti Keloharju, Owen Lamont, Greg Mankiw, Lubos Pastor, Antti Petajisto, Christopher Polk, Jay Shanken, Andrei Shleifer, Jeremy Stein, Sam Thompson, Luis Viceira, and seminar participants at Chicago GSB, Harvard Business School, and the NBER Asset Pricing meeting for helpful comments. We are grateful to Ken French for providing us with some of the data used in this study. All errors and omissions remain our responsibility. Campbell acknowledges the f nancial support of the National Science Foundation.
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Abstract This paper explains the size and value “anomalies” in stock returns using an economically motivated two-beta model. We break the CAPM beta of a stock with the market portfolio into two components, one re f ecting news about the market’s future cash f ows and one re f ecting news about the market’s discount rates. Intertemporal asset pricing theory suggests that the former should have a higher price of risk; thus beta, like cholesterol, comes in “bad” and “good” varieties. Empirically, we F nd that value stocks and small stocks have considerably higher cash- f ow betas than growth stocks and large stocks, and this can explain their higher average returns. The poor performanceoftheCAPMs ince1963isexp la inedbythefactthatgrowthstocksand high-past-beta stocks have predominantly good betas with low risk prices. JEL classi f cation : G12, G14, N22
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1 Introduction How should rational investors measure the risks of stock market investments? What determines the risk premium that will induce rational investors to hold an individual stock at its market weight, rather than overweighting or underweighting it? Ac- cording to the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965), a stock’s risk is summarized by its beta with the market portfolio of all invested wealth. Controlling for beta, no other characteristics of a stock should in f uence the return required by rational investors. It is well known that the CAPM fails to describe average realized stock returns since the early 1960’s. In particular, small stocks and value stocks have delivered higher average returns than their betas can justify. Adding insult to injury, stocks with high past betas have had average returns no higher than stocks of the same size with low past betas. 2 These F ndings tempt investors to tilt their stock portfolios systematically towards small stocks, value stocks, and stocks with low past betas.
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badbeta - Bad Beta, Good Beta John Y. Campbell and Tuomo...

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