A measure of risk - or volatility?
Stock beta is a measure of the price volatility of a stock compared to the rest of the market.
It answers the question: How does the stock’s price move relative to the overall market?
But is stock beta a measure of risk - which is usually assumed? The following discussion considers this question.
Calculating and Interpreting Beta
Beta calculation is performed using a statistical technique called regression analysis. The whole market is assigned a beta of 1.
Stocks that have a beta greater than 1 have greater price volatility than the overall market and are considered to have greater risk.
Stocks with a beta of 1 move up and down with the market.
Stocks with a beta less than 1 have less price volatility than the market as a whole and are considered to have less risk.
Risk relates to return. Investors normally expect that stocks with a higher beta should command a risk premium, that is provide a higher return than the market.
More risk should mean more reward!
So the argument runs like this ...
If the market with a beta of 1 is expected to return 8%, a stock with a beta of 1.5 should return 12%.
If you don’t see that level of return, then the stock is not a good investment possibility.
Stocks with a beta below 1 should be a safer investment, assuming you define risk as volatility. So you should expect a lower return.
A stock’s beta can also be compared to the average beta for its industry sector to get a picture of whether the stock has a different volatility compared to its industry.
My online broker provides a beta value for each stock, and for its sector.
Considerations When Using beta
Factors to take into account about the use of beta as a measure of risk include ...
- beta is based on historical data that is not always an accurate predictor of the future volatility of the stock
- beta does not take into account any new initiatives being undertaken by a company such as acquisitions that may alter the price volatility of the stock
- whether beta as a measure of volatility has any credible relationship with risk for your investment time horizon
- the best use of the beta ratio may be in short-term buying and selling, where price volatility is important.
For long-term value investing, the beta has little relevance. Value investors are more concerned with a company’s fundamentals.
This particularly relates to estimating the company's intrinsic value to provide an approximate means of assessing the risk of buying the stock at a particular price level.
Value investors reject the idea of beta as a measure of risk because it implies that a stock that has fallen sharply in price is more risky than it was before it fell.
A value investor would argue that a company represents a lower-risk investment after its stock has fallen in price, assuming they are still happy with its fundamentals.
For the value investor, buying a stock below its intrinsic value would imply less risk and buying it at a price above the intrinsic value would imply greater risk.
So beta is more relevant to short-term price risk which is a minor concern for value investors.
Return from Stock Beta to Safe Investing
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