One of the by-products of the technology market bubble in the late 1990s and the subsequent correction after 2000 was a sharp distortion in betas, the traditional measure of risk that companies use to estimate their cost of capital.1 The telecommunications, media,and technology (TMT) sectors led a sharp rise and fall in the market, making other industries appear almost flat by comparison and thus lowering non-TMT betas. The beta for electric utilities, for example, dropped from 0.6 in 1998 to 0.1 in 2001, falsely suggesting that the sector's risk level had become unrealistically low—and implying a two-percentage-point decline in the industry's cost of capital.2 Indeed, most non-TMT sectors saw similar significant declines.
Our analysis from 2003 determined that the decline in betas was a distortion caused by the increased weight of TMT shares in broader market indexes, such as the S&P 500, during the bubble. As a result of this distortion, certain sectors (including automotive, chemicals, consumer goods, and utilities) showed a much lower correlation with market indexes, pushing down those sectors' betas. And although TMT valuations had declined significantly by 2003, betas remained skewed because these calculations typically rely on historical performance over the previous three to...