After the Capital Asset Pricing Model (CAPM) was developed in the 1960s and 1970s, financial researchers began to test how this theoretical model actually worked in the real world.
Amidst the expansion of computing power and greater access to data, the 1980s became a critical era for assessing the validity of CAPM as analysts explored the effectiveness of beta in anticipating returns futures
Surprisingly, the general consensus that emerged was that beta’s return forecasting power was quite weak.
In the 60 years or so since CAPM emerged, how well have the model and beta anticipated returns over the decades? To find out, we analyzed all companies listed on the NYSE and NASDAQ and created portfolios of companies based on their systematic risk (beta) using monthly returns and a rolling 12-month calculation.
If a company had a beta of less than 0.5, it was assigned to the low beta portfolio. Firms with a beta greater than 1.5 were assigned to their high beta counterpart.
Using these groupings, we examined the performance of the portfolios over the following year, both on an average and market capitalization-weighted basis. The portfolios were then rebuilt according to new beta calculations each year.
| Average return of the high beta portfolio | Low beta portfolio average return | Market-weighted return of the high-beta portfolio | Market-weighted return of the low-beta portfolio | Percentage of years in accordance with the CAPM | |
| decade of the 1970s | 14.9% | 2.5% | 14.3% | 3.5% | 80% |
| decade of the 1980s | 13.0% | 14.4% | 12.1% | 18.1% | 40% |
| decade of the 1990s | 18.7% | 12.6% | 22.6% | 13.4% | 70% |
| 2000s | 15.2% | 8.9% | 10.7% | 5.2% | 80% |
| 2010s | 14.7% | 9.0% | 13.3% | 12.5% | 91% |
Turns out the 1980s were a terrible time for beta. On an annualized basis, a low-beta portfolio performed 6 percentage points better on average than its high-beta counterpart over the decade, generating a return of 18.14% versus a return of 12.12% .
Next, we examined the percentage of years that reflected the CAPM predictions ordinally across the decade. In only four of the 10 years did CAPM accurately forecast returns. That is, years of positive market performance should correspond to high-beta portfolios outperforming low-beta portfolios and years of negative market performance to low-beta portfolios outperforming high-beta portfolios. This means that the CAPM did worse than a random walk over this time period and helps explain why researchers at the time were so skeptical of the model.
But the 1980s were something of an atypical. As the decades progressed, beta and the CAPM became a better predictor. From 2010 to 2020, CAPM was right in 10 out of 11 years.
In fact, in every decade since the 1980s, a high-beta portfolio generated a premium of just over 5 percentage points over its low-beta counterpart on an annualized basis. That is, the high beta portfolio had an average return of 15.53% compared to the low beta’s return of 10.34%.
All in all, the results highlight that beta is not as bad a predictor of future returns as is often thought. The 1980s were a terrible time for beta and the CAPM, but since that decade, beta has been a decent predictor of future returns.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Derek Horstmeyer
Zach McKannan
