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Testing The Beta Premise

One of the most important issues in finance concerns the relationship between risk and expected return. John Lintner, William Sharpe and Jack Treynor are generally given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM), which was developed in the early 1960s. The CAPM provided the first precise definition of risk and how it drives expected returns.

The CAPM looks at risk and return through a “one-factor” lens, meaning the risk and the return of a portfolio are determined only by its exposure to market beta. Market beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market. The CAPM was the financial world’s operating model for about 30 years.

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