Speculative Betas

Abstract

The risk and return trade-off, the cornerstone of modern asset pricing theory, is often of the wrong sign. Our explanation is that high beta assets are more prone to speculative overpricing than low beta ones. When investors disagree about the prospects of the stock market, high beta assets are more sensitive to this aggregate disagreement and experience a greater divergence of opinion about their payoffs. These assets experience speculative demand from optimistic investors. Short-sales constraints then result in these high beta assets being over-priced. When aggregate disagreement is high, expected returns can actually decrease with beta, especially for stocks with low idiosyncratic variance and hence where the cost of taking speculative positions is smaller. We confirm our theory using a measure of disagreement about stock market earnings.