A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

particularly important for some of the largest investors in the
market.
Changes in the rate of inflation will similarly tend to have a
systematic influence on the returns from common stocks.
This is so for at least two reasons. First, an increase in the
rate of inflation tends to increase interest rates and thus tends
to lower the prices of some equities, as just discussed.
Second, the increase in inflation may squeeze profit margins
for certain groups of companies—public utilities, for
example, which often find that rate increases lag behind
increases in costs. On the other hand, inflation may benefit
the prices of common stocks in the natural resource
industries. Thus, again there are important systematic
relationships between stock returns and economic variables
that may not be captured adequately by a simple beta
measure of risk.
Statistical tests of the influence on security returns of
several systematic risk variables have shown somewhat
promising results. Better explanations than those given by the
CAPM can be obtained for the variation in returns among
different securities by using, in addition to the traditional beta

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measure of risk, a number of systematic risk variables, such
as sensitivity to changes in national income, in interest rates,
and in the rate of inflation. Of course, the APT measures of
risk are beset by some of the same problems faced by the
CAPM beta measure. It is not yet certain how these new
theories will stand up to more extensive examination.
THE FAMA-FRENCH THREE-
FACTOR MODEL
Eugene Fama and Kenneth French have proposed a factor
model, like arbitrage pricing theory, to account for risk. Two
factors are used in addition to beta to describe risk. The
factors derive from their empirical work showing that returns
are related to the size of the company (as measured by the
market capitalization) and to the relationship of its market
price to its book value. Fama-French argue that smaller firms
are relatively risky. One explanation might be that they will
have more difficulty sustaining themselves during
recessionary periods and thus may have more systematic risk
relative to fluctuations in GDP. Fama-French also argue that
stocks with low market prices relative to their book values

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may be in some degree of “financial distress.” These views
are hotly debated, and not everyone agrees that the Fama-
French factors measure risk. But certainly regarding early
2009, when the stocks of major banks sold at very low prices
relative to their book values, it is hard to argue that investors
did not consider them in danger of going bankrupt. And even
those who would argue that low-market-to-book-value stocks
provide higher returns because of investor irrationality find
the Fama-French risk factors useful.