Your Investment Tool Is Failing You
Skip to content
Finance & Accounting Jun 6, 2016

Your Investment Tool Is Failing You

A new tool offers smart investors an improvement over the CAPM.

A new model predicts stock performance better than CAPM

Yevgenia Nayberg

Based on the research of

Matthew R. Lyle

Charles C. Y. Wang

Akash Chattopadhyay

The Capital Asset Pricing Model (CAPM) is the most commonly used tool for predicting stock returns. It is taught in business schools, and it has been used by investors for decades. In 1990, the economist William Sharpe won a Nobel Prize for helping to create it.

But the curious thing about the CAPM is that, for all its influence, it does not actually work.

“We’ve known for a long time that the CAPM doesn’t really predict stock returns and that, empirically, the model is somewhat of a failure,” says Matthew Lyle, an assistant professor of accounting information and management at Kellogg.

In their recent work, Lyle and his coauthor, Charles C.Y. Wang of Harvard, address this long-standing problem by proposing a model that relies on different information than the CAPM. They tested both models against data from the 1970s to 2013 and found “no evidence whatsoever that the CAPM can predict stock returns,” Lyle says. “That, in and of itself, says that essentially there’s nothing there. And we did the exact same exercise using our model and found that we could robustly forecast stock returns up to three years ahead.”

Lyle’s model is also straightforward enough to be useful to portfolio managers and individual investors, drawing on data that is easily available in corporate financial statements.

Risky Business

One reason for the CAPM’s persistence is that there has not been a significantly better model to replace it, despite many attempts. CAPM also persists because it gives formal expression to a piece of common wisdom about investing: there is a connection between risk and reward.

New model offers improvements over CAPM
Karen Freese

A stock’s price movments (or volatility) in relation to the broader market—or “beta”—is central to the CAPM. A stock with a beta of 1 is expected to move one-for-one with the market. Stocks with a low beta (i.e., under 1) tend to be less volatile and move less with the overall market. That is, they tend not to gain as much as the market during an upswing in stock prices, or lose as much during a downturn. Stocks with a high beta, by contrast, are highly sensitive to market swings, losing more than the market during downturns and gaining more during upswings.

“The biggest insight CAPM delivers is that the more exposure a stock has to market-wide upturns and downturns—the more the risk—the higher the expected stock return will be,” Lyle says. “Most people can wrap their heads around that idea. CAPM says you should have higher expected returns if you buy a high-risk firm.”

Back to Basics

While CAPM focuses on a sensitivity to the overall market, Lyle’s model focuses on how accounting fundamentals predict a stock’s performance.

“Most models are based on things that we can’t see,” Lyle says. “We can’t see risk. We know it’s there, but it’s hard to measure. What I’m interested in is: What role does accounting play in coming up with the price of a stock? We can see reported income. We can see reported book value. We can see market value. If you want to try to understand expected returns, or how investors set expected returns, accounting information [is] a fruitful place for future exploration.”

“Lo and behold, when you do it in a rigorous way, out pops this thing that you’ve been trying to figure out for a long time.”

In addition to a stock’s current price, the model’s formula for calculating expected returns depends on two variables: a firm’s book-to-market ratio and its return on equity (ROE).

The book-to-market ratio is calculated by dividing a company’s book value (assets minus liabilities) by its market capitalization (the outstanding shares multiplied by the current price per share). ROE measures how efficiently a company generates profits with shareholders’ money. It is calculated by dividing net income by shareholders’ equity.

Investors have long known that such information is relevant to the performance of a stock over time. But they have lacked a systematic method for applying that intuition to forecasting stock returns. Lyle’s model helps fill that gap.

“People talk about things like the price-to-earnings ratio and earnings growth,” Lyle says. “Our model says, that’s right. Yes, you should be looking there. And here’s a way of combining that information that you’ve been thinking about, along with a couple of other things in the accounting system. And lo and behold, when you do it in a rigorous way, out pops this thing that you’ve been trying to figure out for a long time.”

Minimum Requirements

The model’s performance depends in part on the quality of the accounting data, as well as how far back the numbers go. The ideal is to have several years’ worth of accurate data.

“Essentially, you have to run a regression, or fit the model to historical data,” says Lyle. “Now, an average investor could probably do that. But that is where things get a little more technical. In order to calibrate or fit the model to those inputs, you do need approximately five years of historical data. If you don’t have that, then you would run into some issues, but, with that said, data is also required to estimate the CAPM.”

The Power of (Global) Foresight

The payoff is a tool that can predict expected returns with greater accuracy than the standard model. And it can do so for any firm, provided there is sufficient data to work with.

“Most published models similar to ours are focused on predicting the S&P 500 index or ‘The Market,’” Lyle says. “But if you want to start doing firm-level investments—if you are a fund manager—you’re not going to invest in just the S&P 500.”

Investors can also apply the model to international equities. In a follow-up to their original research, Lyle and Wang (along with a third author, Akash Chattopadhyay of Harvard) tested it in international markets and found that expected returns lined up well with actual returns.

Unlike the CAPM, the model is also able to reliably predict returns at varying time horizons up to three years out. Having a reliable estimate of expected returns from quarter to quarter is “critical in assessing investment opportunities,” as the researchers write, “which can guide investors in tailoring their portfolios to match their desired investment horizons.”

What it all adds up to seems to be the best of both worlds: a relatively easily applied model that delivers a reliable and sophisticated tool for investors.

“In the end,” Lyle says, “I think the big takeaway of the paper is that a relatively simple model that just combines book value, present stock prices, and the profitability of the firm—that tells you a lot about where future stock prices are going. And the CAPM and other CAPM-related models don’t.”

Featured Faculty

Associate Professor of Accounting Information & Management

About the Writer
Theo Anderson is a writer and editor who lives in Chicago.
About the Research

Lyle, Matthew R., and Charles C.Y. Wang. 2015. “The Cross Section of Expected Holding Period Returns and Their Dynamics: A Present Value Approach.” Journal of Financial Economics. 116 No. 3 (June): 505–525.

Chattopadhyay, Akash, Matthew R. Lyle, and Charles C.Y. Wang. 2015. “Accounting Data, Market Values, and the Cross Section of Expected Returns Worldwide.” Harvard Business School Working Paper No. 15-092.

Read the original

Most Popular This Week
  1. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  2. How to Get the Ear of Your CEO—And What to Say When You Have It
    Every interaction with the top boss is an audition for senior leadership.
    employee presents to CEO in elevator
  3. 6 Takeaways on Inflation and the Economy Right Now
    Are we headed into a recession? Kellogg’s Sergio Rebelo breaks down the latest trends.
    inflatable dollar sign tied down with mountains in background
  4. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  5. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  6. How Offering a Product for Free Can Backfire
    It seems counterintuitive, but there are times customers would rather pay a small amount than get something for free.
    people in grocery store aisle choosing cheap over free option of same product.
  7. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  8. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  9. How Much Do Boycotts Affect a Company’s Bottom Line?
    There’s often an opposing camp pushing for a “buycott” to support the company. New research shows which group has more sway.
    grocery store aisle where two groups of people protest. One group is boycotting, while the other is buycotting
  10. 3 Tips for Reinventing Your Career After a Layoff
    It’s crucial to reassess what you want to be doing instead of jumping at the first opportunity.
    woman standing confidently
  11. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  12. 5 Takeaways on the State of ESG Investing
    ESG investing is hot. But what does it actually deliver for society and for shareholders?
    watering can pouring over windmills
  13. Could Bringing Your "Whole Self" to Work Curb Unethical Behavior?
    Organizations would be wise to help employees avoid compartmentalizing their personal and professional identities.
    A star employee brings her whole self to work.
  14. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  15. Why Well-Meaning NGOs Sometimes Do More Harm than Good
    Studies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
    To succeed, foreign aid and health programs need buy-in and coordination with local partners.
  16. Podcast: Does Your Life Reflect What You Value?
    On this episode of The Insightful Leader, a former CEO explains how to organize your life around what really matters—instead of trying to do it all.
  17. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires