Beta Is Still Alive!∗

This paper investigates whether beta can predict the expected return after controlling for the beta instability resulting from shift in the covariance structure. Such a shift is driven by idiosyncratic volatility’s clientele effect: speculative investors prefer stocks with high idiosyncratic volatility. Consequently, these stocks tend to have low future returns from overpricing, and high beta because clientele-based trading also contains systematic component. Indeed, we find that the beta estimate of the current period is positively related to the beta estimate and negatively related to the idiosyncratic volatility measure of the last period. More important, different from existing studies, we find that beta estimates of the current period can significantly explain the cross-sectional differences in future returns of individual stocks, when allowing for an interaction between the current idiosyncratic volatility and the beta estimates. We also show that our simple model can predict the historical expected return well. All results are robust with respect to different measures of beta and idiosyncratic volatility and to different subsamples.