The Risk of Beta – Investor Learning and Prospect Theory

Investors show different behaviour in falling markets and in rising markets. This paper demonstrates that the beta of individual stocks varies across the entire return distribution and that the variation depends on the frequency of the returns. While there is a symmetric u-shape increase for extreme daily returns, there is an asymmetric effect with an increased beta for extreme negative returns for weekly and monthly data. We use all constituents of the EUROSTOXX600 index over the period of 1979 until 2009, and estimate the impact of the index on the constituents for different firm-specific return regimes. The regime-dependent role of systematic risks on individual stocks is explained with investor learning for daily and weekly data and prospect theory for monthly data. The results demonstrate that the risk of a stock can be underestimated or overestimated significantly if conditional means are used and the existence of regimes is ignored.