A stock's price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market.
It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta. Besides, beta offers a clear, quantifiable measure that is easy to work with.
Sure, there are variations on beta depending on things such as the market index used and the time period measured. But broadly speaking, the notion of beta is fairly straightforward. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method. If you are investing based on a stock's fundamentals, beta has plenty of shortcomings.
For starters, beta doesn't incorporate new information. Consider a utility company: let's call it Company X. Company X has been considered a defensive stock with a low beta. When it entered the merchant energy business and assumed more debt, X's historic beta no longer captured the substantial risks the company took on.
At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta. Another troubling factor is that past price movement is a poor predictor of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric.
However, for investors with long-term horizons, it's less useful. The well-worn definition of risk is the possibility of suffering a loss.
Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn't distinguish between upside and downside price movements.
For most investors, downside movements are a risk, while upside ones mean opportunity. Beta doesn't help investors tell the difference.
For most investors, that doesn't make much sense. One measure of the rate of arrival of new factors is the correlation of betas over time. If the factors that drive the market are unchanged, then the beta will continue to be stable and unchanged.
In contrast, the arrival of a new factor has the potential to dramatically change the beta of securities, resulting in low correlation between the betas from one period to the next—if beta is measured over a short enough period to reflect this change. Below we show the correlation on a monthly basis of beta predicted by using the Barra Global Equity Model. The month-to-month correlation is computed as a rank correlation, so the measure as reported here is not sensitive to outliers.
There is no doubt that the changes we are seeing regarding the estimated beta of stocks is unprecedented. The change is probably epitomized by comparing the change in the risk profile of The Walt Disney Co. Both companies are in the entertainment industry. Keep in mind that a stock could have a volatile price and still have a low beta if the volatility isn't correlated with changes in the market.
Also, because beta is based on historical returns, an asset's beta may change over time. While beta measures how an investment may change with the market, alpha measures how well an investment performs relative to the market. They can be used together when researching investment opportunities. Beta is actually a vital component of the capital asset pricing model CAPM. The CAPM formula can be used to estimate the expected return of an asset based, in part, on its beta.
This can then be compared to the asset's actual return to see if it generated alpha — or beat its benchmark without taking on additional risk. It could be important to consider alpha and beta in tandem when you're reviewing investment opportunities. Bortnem shares a simple example of why:. Predicting how much an investment — or your entire portfolio — may move when the market is up or down can be an important component of investing.
If you don't want to experience big swings, you could look for options that have a low beta. Or, hedge against high beta investments with investments that have a negative beta.
If you're not as risk averse, you could look for options with a higher beta that could lead to larger returns. But be careful, a high beta can also mean bigger losses. Also, remember that beta doesn't measure factors that may be specific to a single company or asset. It can be helpful in building your portfolio, but you want to consider beta within a larger context and only as one once piece of analysis.
Yields in a number of markets in Europe and Asia are lower than stateside, or even negative. Inflation could still dampen returns for stocks if bond yields start climbing steadily. Real wages adjusted for inflation have also slipped lately, making it tougher for consumers to buy more of anything. Overall, the bull market is clearly intact as the economic recovery continues.
But investors may become more selective towards stocks if the rising price environment persists, and favor those of companies with the capability of consistently passing along rising costs.
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