Portfolio Management

Accuracy of Historical Betas

Accuracy of Historical Betas
Now, assume we have different betas for different stocks. The beta we calculate for
any stock will be, in part, a function of the true underlying beta and, in part, a
function of sampling error.
If we compute a very high estimate of beta for a stock, we have an increased
probability that we have a positive sampling error, whereas if we compute a very low
estimate of beta, we have an increased chance that we have a negative sampling error.
If this scenario is correct, we should find that betas, on the average, tend to converge
to 1 in successive time periods
Measuring the Tendency of Betas to Regress toward 1—
Blume’s Technique

Because betas in the forecast period tend to be closer to 1 than the estimate obtained
from historical data, the next obvious step is to try to modify past betas to capture this
tendency.

Blume (1975) was the first to propose a scheme for doing so.

He corrected past betas by directly measuring this adjustment toward 1 and assuming
that the adjustment in one period is a good estimate of the adjustment in the next.

We could calculate the betas for all stocks for the period 1948–1954.
We could then calculate the betas for these same stocks for the period 1955–1961.
We could then regress the betas for the later period against the betas for the earlier
period,
Measuring the Tendency of Betas to Regress toward 1—
Blume’s Technique

The equation lowers high values of beta and

raises low values.

One more characteristic of this equation

should be noted: it modifies the average level
of betas for the population of stocks.

Because it measures the relationship between

betas over two periods, if the average beta
increased over these two periods, it assumes
that average betas will increase over the next
period.
Measuring the Tendency of Betas to Regress toward 1—
Vasicek’s Technique
Recall that the actual beta in the forecast period tends to be closer to the average beta
than is the estimate obtained from historical data.
A straightforward way to adjust for this tendency is simply to adjust each beta toward
the average beta.
For example, taking one-half of the historical beta and adding it to one-half of the
average beta moves each historical beta halfway toward the average. This technique is
widely used.
It would be desirable not to adjust all stocks the same amount toward the average but
rather to have the adjustment depend on the size of the uncertainty (sampling error)
about beta.
The larger the sampling error, the greater the chance of large differences from the
average being due to sampling error, and the greater the adjustment.
Measuring the Tendency of Betas to Regress toward 1—
Vasicek’s Technique
Vasicek (1973) suggested weights of;

Note that these weights add up to 1 and the forecast of beta for security i is

This weighting procedure adjusts observations with large standard errors further toward
the mean than it adjusts observations with small standard errors