From Morningstar:

Professor William Sharpe won the 1990 Nobel Memorial Prize in Economic Sciences for developing the capital asset pricing model, which assesses a stock’s expected return based on its “beta”. Beta measures how a stock’s price tends to change, based on the market’s overall performance, with 1.0 as the market beta. Stocks with higher or lower betas will shift a certain percentage further or less, respectively.

Sharpe’s insight led to the understanding that a portfolio’s expected return is determined by its aggregate beta, or the asset-weighted average of its equity holdings. This suggests the level of a portfolio’s returns, assuming a given stock market result. Beta cannot predict individual stock or portfolio performances over short periods, but rather provides hypotheses for long-term actions.

Despite its initial theoretical success, Sharpe’s model, using beta as the sole variable to explain stock returns, was refuted by Eugene Fama and Kenneth French. Their research showed no link between beta and stock performances and proved that value stocks outperformed growth stocks, invalidating beta’s effectiveness as a predictor.

Vanguard created two style-index funds, with observers testing beta’s effectiveness in practice. Initially, the findings did not align with Sharpe’s theory as growth stocks did not outgain value stocks, contrary to beta predictions. However, over the years, the relative returns flipped, and the pattern neatly reversed, with Vanguard Growth Index eventually outgaining its sibling by almost 2 percentage points per year.

The post-1992 record showed that beta’s predictive power appeared non-existent by the early 2000s, discrediting its effectiveness. However, the 31-year record in its entirety demonstrated that beta’s predictions did not hold true, raising doubts about the reliability of the model as a meaningful predictor.

Investment theory suggests that stocks generally outgain bonds over time, especially for developed nations with healthy economies. However, investment theory may contain some truth, but not enough to serve as a meaningful predictor. This principle should be considered when presented with an investment strategy “proved” by academics.



Read more: Beta is Back | Morningstar