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Bias in estimating the systematic risk of extreme performers: Implications for financial analysis, the leverage effect, and long-run reversals

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  • Jones, Steven L.
  • Yeoman, John C.
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    Abstract

    We show how bias can arise systematically in the beta estimates of extreme performers when long-run return reversals are present and partly, or wholly, due to sign changes in unanticipated factor realizations. Our evidence is consistent with this bias being responsible for the large shifts in the beta estimates of extreme performers, more so than the leverage effect, which has been the predominant explanation in prior literature. Bias in these contemporaneous realized betas, estimated with the same returns that are to be risk adjusted, arises due to the general problem of “overconditioning,” where betas are estimated conditional on information that is not yet known. Several methods for conditioning betas on out-of-sample returns are evaluated and found to be lacking, although some offer improvement under certain circumstances. We also show evidence of this bias in the Fama–French Three-factor loadings of extreme performers. Our findings indicate not only that previous studies of long-run reversals understate contrarian profits but that bias is prevalent in the OLS beta estimates of extreme performers, and this has implications for estimating the cost of capital and measuring long-run performance. We offer recommendations for identifying when this bias is likely present, as well as general methods to correct for it.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Corporate Finance.

    Volume (Year): 18 (2012)
    Issue (Month): 1 ()
    Pages: 1-21

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    Handle: RePEc:eee:corfin:v:18:y:2012:i:1:p:1-21

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    Web page: http://www.elsevier.com/locate/jcorpfin

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    Keywords: Contrarian; Estimation bias; Leverage; Long-run reversals; Overreaction; Time-varying risk;

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