Good and bad betas

Categories: Economics and finance stubs

An extension of the Capital Asset Pricing Model, the idea of "good" and "bad" betas attempt to account for why CAPM has done so poorly in predicting stock prices after 1963.

Developed by John Campbell and Tuomo Vuolteenaho in their article, Bad Beta, Good Beta, Campbell and Vuolteenaho propose that beta--the portion of the model that encapsulates risk (and by extension, the price of the assets)--has a dual nature.

• The good part of beta captures news about the market's future discount rate. It's "good" because the greater the discount rate, the better off growth stocks and large stocks are.
• The bad part of beta is defined by the news concerning the asset's future cash flow. It's "bad" because the greater the future cash flows, the greater the voliatility of the market (pertains mostly to value stocks and small stocks).

During the period in question (after 1963), small and value stocks have had higher cash flow betas than growth and large stocks because of their higher than average returns. Also, growth and large stocks had good betas with low risk prices. Thus the original CAPM performed poorly.