Region: With Kenneth French, you’ve said that the capital asset pricing model (CAPM) developed by John Lintner and William Sharpe has “fatal problems” in explaining stock market returns because of its reliance on beta [the volatility of an individual stock relative to overall market volatility]. And you’ve found that two other factors are crucial for determining prices. Can you tell us about these factors? Are they inefficiencies, or do they represent hidden risk? And is the CAPM truly dead?
Fama: Let me first tell you what the returns evidence says, and then we can talk about how to interpret it. The returns evidence basically says that if you look at the CAPM market beta, it’s not enough to describe the cross section of average returns.
The CAPM says that all you need to know are these market betas, market sensitivities, in order to fully describe the cross section of average returns. What you find is that other variables contribute to the explanation of average returns above and beyond what you get from beta. Indeed, over the last 50 years, you get very little at all from beta.
The two variables that we’ve focused on are market capitalization (the financial profession calls it size, a misnomer because it’s really market capitalization) and the book-to-market ratio, the ratio of the book value of a common equity to its market value. Now, there’s no magic in that ratio. The ratio of almost anything to price will work as well. These are the two variables.
So, small-cap stocks have higher average returns than large-cap stocks, and stocks with higher ratios of book value to market value have higher returns than low book-to-market stocks. Low book-to-market stocks tend to be growth stocks. High book-to-market stocks tend to be relatively more distressed; they’re what people call value stocks. That’s given rise to what the finance profession—academic as well as applied—calls the size premium and the value premium. The value premium tends to be bigger.
So the issue then is, Are these risk factors or market inefficiencies? One group of people says they’re market inefficiencies—particularly the value premium. The behaviorists tend to say the value premium is a market inefficiency. Their story is: The market overreacts to good and bad past times. It doesn’t understand that things tend to mean revert. So growth companies that have done very well tend to be overpriced, and value companies that have done poorly tend to be underpriced, and then the market realizes this and corrects it. And this story says, basically, that people are dumb; they never learn. So every generation of growth stocks and value stocks goes through the same sort of cycle.
That’s not too appealing to an economist—the idea that people never learn about these things—but that is the behavioral story. And initially they said these are arbitrage opportunities because if you go long value stocks and short growth stocks, you get something with a variance close to zero.
But French and I pointed out that if you do that, you get something with a variance very close to the market variance, not zero. It’s quite a risky strategy. And the premium is about the size of the market premium. So it looks and smells like a risk premium. And we developed a three-factor model with a size premium in addition, basically the difference between the returns on small stocks and big stocks.
So, our model has three factors. Every asset pricing model says you need the market in there. Then they differ on how many other things you need. The CAPM says you only need the market. We basically say a minimum of two other factors seem to be necessary. And these two do a pretty good job.
There’s still a third explanation, which is not based on overreaction. It says that people just don’t like small stocks and value stocks. There’s some amount of utility that people get from the nature of the stocks that they hold. So they like big stocks and they like growth stocks, and they’re willing to hold them even though they have lower average returns.
Now you can’t have an arbitrage opportunity there because then there’d be a sure profit. But the fact that they look like risk factors can sustain that story. You can’t tell the difference between that story and a risk story.
New book: Sharpe's 'Investors and Markets'
The Asset Pricing and Portfolio Choice Simulator
Perry Mehrling, Fischer Black, and Finance
Asset Prices and Portfolio Choice
Draft chapters of William Sharpe's Investors and Markets: Portfolio Choices, Asset Prices and Invetment Advice
Fama's two books are online; Foundations of Finance, 1976; The Theory of Finance, with Merton Miller, 1972