The wicked smart economists at Marginal Revolution have made a critical breakthrough, improving the CAPM model commonly used by financiers.
The Capital Asset Pricing Model specifies that the expected return on an asset is a function of the market rate of return plus another factor (“Beta”) for the covariance of that asset with the market portfolio. The intuition is that pro-cyclical assets are riskier and thus they must give you higher expected return. But I don’t buy the whole Beta bit, especially not for equity markets:
For risky equity assets in the United States, my preferred economic model is simple. Expected return equals seven. That is my model, “Seven.”
Here at Long Or Short, we don’t generally use CAPM due to our proprietary – and superior – 126 factor model. However, we sometimes use CAPM to see what the plebes are thinking and, in such cases, we will use a Beta of 1 and Expected Return of 7.