The Capital Asset Pricing Model specifies that the expected return on an asset is a function of the market rate of return plus another factor ("Beta") for the covariance of that asset with the market portfolio. The intuition is that pro-cyclical assets are riskier and thus they must give you higher expected return. But I don’t buy the whole Beta bit, especially not for equity markets:
1. For the marginal investor today, the marginal utility of money doesn’t vary much across world-states. Let’s say you expect to earn a few million dollars over your lifetime and you have access to capital markets. How much do you care about the covariance of a single stock?
2. Tossing in any second variable will improve predictive performance of the model. To me the broader multi-factor models just look like data mining.
3. I can see that Beta might lower the expected return to holding gold, a traditional safe harbor in tough times. I just don’t believe Beta matters for most equity assets. Yes construction is pro-cyclical but does this affect real world thinking about which stocks to buy? I think views on cyclicality are dwarfed by idiosyncratic expectational factors about particular facts of the world.
4. Unlike say, profit maximization, CAPM-reasoning will not evolve in the marketplace unless people are at some level aware of the fundamental principals of the theory and take care to minimize systematic risk. If you are ignorant of CAPM you might have lower utility but you needn’t earn less money over time. You don’t drop out of the marketplace as a broken down beggar.
5. People compartmentalize their fears. Insofar as you worry about systematic risk it will affect your human capital decisions and real estate decisions, not your equity investments.
6. Risk affects your equity investments by getting you to diversify. The story ends there. Greater fear might mean you buy more individual stocks, but you don’t look into their Betas to prefer one stock over another.
7. Did I mention that ex post Beta is not always accurate as a predictor of future Beta?
8. Fama and French have shown that the line connecting Beta and expected returns has an almost flat slope, at least if we adjust for the size of a firm relative to its book value.
For risky equity assets in the United States, my preferred economic model is simple. Expected return equals seven. That is my model, "Seven."
Plus of course an random or error term. How’s that for Occam’s Razor?