Beta term in investing
Keep in mind that both alpha and beta are based on historical data. As every investment prospectus warns, past performance is no guarantee of future results. Understanding "smart beta" As explained above, a stock's sensitivity to movements in the broader market is measured by its beta. By understanding a stock's beta, investors can theoretically build a portfolio that matches their risk tolerance. In recent years, however, a new approach to index investing—smart beta—has started to gain traction among investors.
Smart beta refers to an enhanced indexing strategy that seeks to exploit certain performance factors in an attempt to outperform a benchmark index. In this sense, smart beta differs fundamentally from a traditional passive indexing strategy.
Smart beta strategies also differ from actively managed mutual funds, in which a fund manager chooses among individual stocks or sectors in an effort to beat a benchmark index. Smart beta strategies seek to enhance returns, improve diversification, and reduce risk by investing in customized indexes or ETFs based on one or more predetermined "factors. Many traditional index funds and ETFs are "capitalization-weighted. Stocks with higher market capitalizations are weighted more heavily than stocks with lower market capitalizations.
As a result, it's possible for a handful of highly valued stocks to represent a large percentage of the index's total value. Rather than relying solely on market exposure to determine a stock's performance relative to its index, smart beta strategies allocate and rebalance portfolio holdings by relying on one or more factors. A factor is simply an attribute that might help to drive risk or returns, such as quality or size. For example, stocks of companies that generate superior profits, strong balance sheets, and stable cash flows are considered high quality, and tend to outperform the market over time.
Similarly, small-cap stocks have historically outperformed large-cap stocks, although leadership can shift over shorter periods. Most factors are not highly correlated with one another, and different factors may perform well at different times. If a strategy that blends components of active and passive investing appeals to you, you might want to consider investing in smart beta strategies. Next steps to consider.
Alpha measures outperformance after volatility has been considered. If a stock has a beta of say 1. To achieve alpha, the stock would need to move up more than 1. The formula is illustrated by Business Insider below. Business Insider Graphical Illustration of 'Beta' Beta can also be portrayed graphically as the slope of a graph of a stock's returns vs.
On the Seeking Alpha website, it appears on the main stock page in the Risk section as shown below. Beta can be calculated for a period of several months to as long as several years, so it may not be exactly the same from different sources. Also, no relationship between a stock and the market is perfect, so beta represents an approximation at best and will vary over time for all stocks. One aspect of a company that can significantly alter its beta is its debt structure.
The more debt a company takes on, the more leverage it will have and its beta will increase accordingly. Advantages Manage expectations: Beta represents a good indication of whether a particular stock will move more or less than the market as a percentage. Manage your portfolio volatility: Beta can help you manage the volatility of your overall portfolio and change it to accommodate changing market conditions.
Simple: Beta is a relatively simple concept to understand and the number is readily available. Disadvantages Beta is not constant: Betas will change as the nature of both the stock in question and the market as a whole evolve.
Companies mature or change their businesses. The business and economic climate change. Beta, therefore, changes over time. Not reliable for very short-term projections: In addition, statistics become more accurate over longer periods of time. Therefore, using beta for short-term projections such as only a few days or weeks is particularly susceptible to error.
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In order to make sure that a specific stock is being compared to the right benchmark, it should have a high R-squared value in relation to the benchmark. R-squared is a statistical measure that shows the percentage of a security's historical price movements that can be explained by movements in the benchmark index.
When using beta to determine the degree of systematic risk, a security with a high R-squared value, in relation to its benchmark, could indicate a more relevant benchmark. One way for a stock investor to think about risk is to split it into two categories.
The first category is called systematic risk, which is the risk of the entire market declining. The financial crisis in is an example of a systematic-risk event; no amount of diversification could have prevented investors from losing value in their stock portfolios. Systematic risk is also known as un-diversifiable risk. Unsystematic risk , also known as diversifiable risk, is the uncertainty associated with an individual stock or industry. For example, the surprise announcement that the company Lumber Liquidators LL had been selling hardwood flooring with dangerous levels of formaldehyde in is an example of unsystematic risk.
It was risk that was specific to that company. Unsystematic risk can be partially mitigated through diversification. A stock's beta will change over time as it relates a stock's performance to the returns of the overall market, which is a dynamic process. A stock with a beta of 1. Adding a stock to a portfolio with a beta of 1. Including this stock in a portfolio makes it less risky than the same portfolio without the stock.
For example, utility stocks often have low betas because they tend to move more slowly than market averages. For example, if a stock's beta is 1. Technology stocks and small cap stocks tend to have higher betas than the market benchmark.
Negative Beta Value Some stocks have negative betas. A beta of Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common. Beta in Theory vs.
Beta in Practice The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective. However, financial markets are prone to large surprises. A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend.
It's a convenient measure that can be used to calculate the costs of equity used in a valuation method. The Disadvantages of Beta 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.
Assessing Risk 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. There is an interesting quote from Warren Buffett regarding the academic community and its attitude towards value investing : "Well, it may be all right in practice, but it will never work in theory. A value investor would argue that a company represents a lower-risk investment after it falls in value—investors can get the same stock at a lower price despite the rise in the stock's beta following its decline.
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For example, if a stock's beta is 1. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. Negative Beta Value Some stocks have negative betas. A beta of Put options and inverse ETFs are designed to have negative betas. There are also a few industry groups, like gold miners, where a negative beta is also common.
Beta in Theory vs. Beta in Practice The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective. However, financial markets are prone to large surprises.
A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases risk in a portfolio only if the investor defines risk strictly in terms of volatility rather than as the potential for losses.
Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may add gains as well. It's recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.
Drawbacks of Beta While beta can offer some useful information when evaluating a stock, it does have some limitations. Beta is useful in determining a security's short-term risk, and for analyzing volatility to arrive at equity costs when using the CAPM. However, since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict a stock's future movements.
Beta is also less useful for long-term investments since a stock's volatility can change significantly from year to year, depending upon the company's growth stage and other factors. Furthermore, the beta measure on a particular stock tends to jump around over time, which makes it unreliable as a stable measure. What Is a Good Beta for a Stock? Beta is used as a proxy for a stock's riskiness or volatility relative to the broader market.
A good beta will, therefore, rely on your risk tolerance and goals. If you wish to replicate the broader market in your portfolio, for instance via an index ETF, a beta of 1. If you are a conservative investor looking to preserve principal, a lower beta may be more appropriate. In a bull market, betas greater than 1. Is Beta a Good Measure of Risk? Many experts agree that while Beta provides some information about risk, it is not an effective measure of risk on its own.
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. Assessing Risk 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.
There is an interesting quote from Warren Buffett regarding the academic community and its attitude towards value investing : "Well, it may be all right in practice, but it will never work in theory. A value investor would argue that a company represents a lower-risk investment after it falls in value—investors can get the same stock at a lower price despite the rise in the stock's beta following its decline.
Beta says nothing about the price paid for the stock in relation to fundamental factors like changes in company leadership, new product discoveries, or future cash flows. A stock's beta will change over time because it compares the stock's return with the returns of the overall market. Benjamin Graham, the "father of value investing," and his modern advocates tried to spot well-run companies with a "margin of safety"—that is, an ability to withstand unpleasant surprises.
Some elements of safety come from the balance sheet , like having a low ratio of debt-to-total capital. Some come from the consistency of growth, in earnings, or dividends. An important one comes from not overpaying. For example, stocks trading at low multiples of their earnings are viewed as safer than stocks at high multiples, although this is not always the case. The Bottom Line Ultimately, it's important for investors to make the distinction between short-term risk—where beta and price volatility are useful—and longer-term, fundamental risk, where big-picture risk factors are more telling.
High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities. Article Sources Investopedia requires writers to use primary sources to support their work.
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