Estimation of Expected Return: CAPM vs Fama and French

Abstract:     
Most practitioners favour a one factor model (CAPM) when estimating expected return for an individual stock. For estimation of portfolio returns academics recommend the Fama and French three factor model. The main objective of this paper is to compare the performance of these two models for individual stocks. First, estimates for individual stock returns based on CAPM are obtained using different time frames, data frequencies, and indexes. It is found that five years of monthly data and an equal-weighted index, as opposed to the commonly recommended value-weighted index, provide the best estimate. However performance of the model is very poor; it explains on average three percent of differences in returns. Then, estimates for individual stock returns are obtained based on the Fama and French model using five years of monthly data. This model, however, does not do much better; independent of the index used it explains on average five percent of differences in returns. These results provide a possible explanation for why CAPM is used so extensively by practitioners; the additional cost associated with Fama and French is not justified. However, they also bring into question the use of either model for estimation of individual stock returns.

Number of Pages in PDF File: 26

Keywords: Capital Asset Pricing Model CAPM, Fama and French three factor model, beta estimation

JEL Classification: G11, G12, G31

working papers series