The Cross-Section of Expected Stock Returns

The central prediction of the asset-pricing model of Sharpe (1964), Lintner (1965), and Black (1972) is that the market portfolio of invested wealth is mean-variance efficient in the sense of Markowitz (1959). The efficiency of the market portfolio implies that: 1. expected returns on securities are a positive linear function of their market betas (the slope in the regression of a security‘s return on the market‘s return), and 2. market betas suffice to describe the cross-section of expected returns. The central prediction of the model proposed by Sharpe, Lintner, and Black is tested. The results show that 2 easily measured variables, size and book-to-market equity, provide a simple and powerful characterization of the cross-section of average stock returns for the 1963-1990 period. Further, when the tests allow for variation in beta that is unrelated to size, the relation between market beta and average return is flat, even when beta is the only explanatory variable.