Forecasting Beta: How Well Does the ‘Five‐Year Rule of Thumb’ Do?

Abstract

CAPM betas are generally estimated from historical data and applied to a future period. There is widespread evidence that the CAPM betas vary considerably over time and this raises two questions: can this variation be explained and can it be forecast better than the ‘five‐year rule of thumb’ (i.e using the most recently estimated beta)? We estimate time‐varying betas and explain the time‐variation in the betas using regression models which we subsequently use for forecasting. We find that forecasting equations have good explanatory power but that their forecasts are dominated, on average, by the five‐year rule of thumb.