Abstract
In this paper we show that it is the beta reversal among a small group of stocks that prevents the CAPM beta from predicting individual stocks’ expected returns as documented by Fama and French (1992). These stocks tend to have both large beta and high idiosyncratic volatility. Consequently, even when the CAPM holds period-by-period, the confounding effect of beta reversal diminishes the significance of the CAPM beta in the cross-sectional tests. The cross-sectional explanatory power of beta is restored after we take into account the beta reversal effect in each of the three ways. More important, the market risk premium estimated from cross-sectional regression analysis is almost identical to the historical average of market excess returns. All results are robust with respect to different measures of beta and idiosyncratic volatility as well as different subsamples. We also find that beta reversal is likely to be a result of several factors including the wealth effect, earnings announcement effect, and real option realization.
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