Time-Varying Beta: Autocorrelation and Autoregressive Time Series

“[T]ime is the longest distance between two places.”1 This book has focused thus far on bifurcating beta in financial space—that is, on either side of mean rates of return or some other target. It has analyzed beta in recognition of two distinct but related departures from the conventions of modern portfolio theory, the capital asset pricing model (CAPM), and the efficient capital markets hypothesis. Financial markets are both abnormal and irrational. They are abnormal in the sense that they violate the central limit theorem and other properties of the normal, Gaussian distribution. Furthermore, real investors respond to such abnormalities in ways that deviate from the neoclassical assumption of perfect rationality and dispassionate maximization of individual or institutional welfare. Even if we cannot describe a mechanism by which human behavior causes market abnormalities or vice versa, or otherwise demonstrate a causal link, we can show that market abnormality and human irrationality travel together—that they are strongly correlated.