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 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. 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.
How to Use Beta
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 portfolio.
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.
The Pros and Cons of Beta
There are a few advantages and disadvantages to using beta.
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 investors, 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.
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