Answer to Question #249646 in Macroeconomics for Ricardo J

Question

Can you explain the paper 'Bad Beta, Good Beta' Campbell, J.Y., & Vuolteenaho, T. 2004 ? With math explanation or example

Answer 1

The paper 'Bad beta, Good beta' explains the size and value abnormalities in stock returns using an economically motivated two beta model. The Capital Asset Pricing Model CAPM beta of a stock is broken down with the market portfolio into two components: one component reflects news about the market cashflows in the future and the other component reflects on the discount rates of the market.

We find out empirically that small stocks and value stocks have considerably higher cash flow betas than large stocks and growth stocks. This explains their higher average returns.

The poor performance of the CAPM from back in 1963 is illustrated such that growth stocks and high beta stocks in the past have predominated with good betas which have low risk prices. According to CAPM of Sharpe (1964), the risk of a stock is summarised by its beta with the market portfolio of all invested wealth. No other characteristics of a stock should affect the return needed by a rational investor with beta being controlled.

Returns on the market portfolio have two components. The recognition of the difference between these two components can do away with the incentive to overweight value, small and low beta stocks. When investors receive bad news about future cash flows, the value of the market may fall. It may however also fall due to increase in discount rate or cost of capital that investors apply to the cashflows. In case 1, wealth declines while investment opportunities are unaffected. In case 2, wealth declines while investment opportunities are increased.

This concept is summarised by saying that beta, like cholesterol, has a bad variety and a good variety. The return on stock that is required is determined by its bad cashflow beta and its good discount rate beta and not by its overall beta with the market. Good beta is not good in absolute terms, but in relation to other type of beta.