Assessing and understanding the risks associated with investment is one of the biggest decisions an investor has to make. It’s important to know how to measure, understand and express the level of risk that you face when investing.
One of the most common ways to do this is by using a statistical measure known as “beta.” Let’s take a look at what it is, how you can use it and the advantages and disadvantages it brings.
Defining a Stock’s Beta
Beta is the measurement of an asset’s or portfolio’s risk in relation to the rest of the market (Note: This is the way it is supposed to be used according to the accepted principles. Like most other value investors, we disagree that beta describes the actual risk in an investment (See: beta finance). According to us, it is at best a description of the volatility in the asset. Please read this theoretical explanation and then you can decide for yourself). This number is used as part of the capital asset pricing model (CAPM). CAPM is used to calculate the anticipated return on an investment, based on the asset’s beta and the expected returns of the market.
Beta is also commonly known as the beta coefficient.
So, here’s how it works. The market, by default, has a beta measurement of 1.0. Individual stocks are ranked according to how they differ from the market baseline. If a stock swings more than the market baseline, then it has a higher beta. If it swings less, then it has lower beta.
Learn more: how to pick a stock to invest in
How to Use Beta to Measure Risk and Determine Valuation
Now that you know what beta means in stocks, let’s look at how it can be used.
Beta is useful when determining whether the risk is worth the potential return on an investment. Higher-beta stocks are riskier, but they typically have the chance for greater return than lower-beta, lower-risk stocks. To give an example, a stock with a beta of 1.75 will offer 1.75 times the typical market return.
Beta represents systemic risk – risk that can’t be diluted by diversification of your investment portfolios.
There are a few things to keep in mind when evaluating beta.
– Beta levels can change over time.
– Beta is not necessarily a complete and comprehensive measure of risk.
– Beta measures co-movement, not volatility.
Learn more: basic investment terms
Is a High Beta Good or Bad?
A high beta stock indicates that the stock moves more than the total stock market index. When taken as a measure of volatility, this means that the stock price sees greater swings than the stock market as a whole. However, if the stock market as a whole appreciates over time, the high beta stock will also appreciate over time (as long as the stock stays correlated with the market).
If you are an investor that has low tolerance for price swings, a high beta stock will not be a comfortable place to be for you. However, if you can stomach volatility, high beta can also deliver better returns than the benchmark index – in which case you may find it desirable.
A stock’s beta changes over time, so this needs to be evaluated on an ongoing basis.
You can increase or decrease the beta of your portfolio by increasing or decreasing leverage in your portfolio. Portfolio betas can be managed down, even if the individual stock betas are high, by ensuring that individual stocks are uncorrelated and the risks hedge out.
The Pros and Cons of Beta
There are a few advantages and disadvantages to using beta.
See also: Value Stocks Definition
Advantages
– Beta is a useful measurement for CAPM
– It’s a straightforward, quantifiable measure of risk
– Knowing risk levels is helpful when investing and determining costs of equity
Disadvantages
– Beta looks backwards, which makes it less useful for predicting future stock movements
– Beta doesn’t incorporate or account for new information
– For long term investments, beta isn’t as useful, since it can change greatly over time
In the end, beta is a useful tool for determining short-term risk and for calculating quantifiable measures of volatility to aid in finding equity costs. It has its pros and cons – like any investing tool – but can be a great way to establish the stability and the volatility in your portfolio. As for it being a measure of risk that is useful to long term value investors, just avoid it.