Question

In the market for common stocks, some economists say that this market is “efficient,” so that there is no way to beat the return of the market as a whole but by buying stocks with “betas” greater than 1. Present the argument for this claim. Why do you think there might be evidence that isn’t consistent with this claim but that still can’t be exploited to make riskless profits systematically in the stock market?

Answer 1

By definition, Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.

Also, by definition, efficient market hyposthesis states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervaluedstocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

Hence, a beta of 1 indicates that the security's price moves with the market. A beta of less than 1 means that the security is theoretically less volatile than the market. A beta of greater than 1 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Conversely, if an ETF's beta is 0.65, it is theoretically 35% less volatile than the market

Having betas greater than 1 would mean as market improves by 1%, our stock would increase by beta (>1) percent. This means that if we want to beat the return of the market as a whole, we need to buy stocks with “betas” greater than 1.

There might be evidence that isn’t consistent with this claim but that still can’t be exploited to make riskless profits systematically in the stock market because if the market increases by 1%, our profits are good, but when market moves down, we lose. Since we cannot perfectly know if the market would go up or down, we can't make riskless profits.