Why the Low Returns to Beta and Other Forms of Risk

Abstract

High–beta stocks typically fail to outperform low–beta stocks. Investors have heterogeneous opinions about value, and the difference between the return expected by the marginal investor and by the typical investor increases with the divergence of opinion. The author suggests that the divergence of opinion diminishes following an initial public offering, producing long–run underperformance of such offerings. Because divergence of opinion, uncertainty, and beta risk are correlated, according to the author, this causes an uncertainty–induced bias that increases with beta, producing a relatively flat security market line, flatter than the risk–return relationship anticipated by the typical investor. An implication of this theory is that investors can improve their return relative to risk by exploiting the flatness of the security market line.

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