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8/3/2019 BITA Studies

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BETA: Gauging price fluctuations

In investing, beta does not refer to fraternities, product testing or VHS' old competition - in

investing, beta is a measurement of market risk, orvolatility. It is because of this risk that some

people don't want to invest in stocks. These risk-averse investors can't stomach stocks' greater

tendency to fluctuate in price. Sure, there is always the possibility that a stock will lose some or all

of its value, but volatility also makes it possible for investors to make a great deal of money - if

they make the right choices.

What Is the Beta?

Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall

market. In other words, it gives a sense of the stock's market risk compared to the greater market.

Beta is used also to compare a stock's market risk to that of other stocks. Investment analysts

use the Greek letter '' to represent beta.

This measure is calculated using regression analysis. A beta of 1 indicates that the security's

price tends to move with the market. A beta greater than 1 indicates that the security's price tends

to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than

the market. Many utility stocks have a beta of less than 1, and, conversely, many high-tech

Nasdaq-listed stocks have a beta greater than 1.

Essentially, beta expresses the fundamental tradeoffbetween minimizing risk and maximizing

return. Let's give an illustration. Say a company has a beta of 2. This means it is two times asvolatile as the overall market. Let's say we expect the market to provide a return of 10% on an

investment. We would expect the company to return 20%. On the other hand, if the market were

to decline and provide a return of -6%, investors in that company could expect a return of -12% (a

loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a

market return of 10% would mean a 5% gain for the company. (For further reading, see Beta:

Know The Risk.)

Here is a basic guide to various betas:

Negative beta - A beta less than 0 - which would indicate an inverse relation to the

market - is possible but highly unlikely. Some investors used to believe that gold and gold

stocks should have negative betas because they tended to do better when the stock

market declined, but this hasn't proved to be true over the long term.

Beta of 0- Basically, cash has a beta of 0. In other words, regardless of which way the

market moves, the value of cash remains unchanged (given no inflation).
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Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of

less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.

Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the

overall market, against which other stocks and their betas are measured. The S&P 500 is

such an index. If a stock has a beta of one, it will move the same amount and direction asthe index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.

Beta greater than 1 - This denotes a volatility that is greater than the broad-based index.

Again, as we mentioned above, many technology companies on the Nasdaq have a beta

higher than 1.

Beta greater than 100- This is impossible as it essentially denotes a volatility that is 100

times greater than the market. If a stock had a beta of 100, it would be expected to go to

0 on any decline in the stock market. If you ever see a beta of over 100 on a research

site it is usually the result of a statistical error, or the given stock has experienced large

swings due to low liquidity, such as an over-the-counter stock. For the most part, stocks

of well-known companies rarely ever have a beta higher than 4.

Why You Should Know What Beta Is

Are you prepared to take a loss on your investments? Many people are not and therefore opt for

investments with low volatility. Other people are willing to take on additional risk because with it

they receive the possibility of increased reward. It is very important that investors not only have agood understanding of theirrisk tolerance, but also know which investments match their risk

preferences.

And, by using beta to measure volatility, you can better choose those securities that meet your

criteria for risk. Investors who are very risk averse should put their money into investments with

low betas such as utility stocks and Treasury bills. Those investors who are willing to take on

more risk may want to invest in stocks with higher betas.

Many brokerage firms calculate the betas of securities they trade and then publish their

calculations in a beta book. These books offer estimates of the beta for almost any publicly-

traded company. The problem is that most of us don't have access to these brokerage books, and

the calculation for beta can often be confusing, even for experienced investors.
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However, there are other resources. One of the better websites that publishes beta is yahoo!

finance (enter your company name then, click on Key Statistics and look under Stock Price

History). The beta that is calculated on Yahoo compares the activity of the stock over the last five

years and compares it to the S&P 500. A beta of "0.00" simply means that the stock either is a

new issue or doesn't yet have a beta calculated for it.

Warnings about Beta

The most important caveat for using beta to make investment decisions is that beta is a historical

measure of a stock's volatility. Past beta figures or historical volatility does not necessarily predict

future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee

that in a year the beta will be the same. One study by Gene Fama and Ken French called "The

Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of Finance) on the

reliability of past beta concluded that for individual stocks past beta is not a good predictor offuture beta. An interesting finding in this study is that betas seem to revert back to the mean. This

means that higher betas tend to fall back towards 1 and lower betas tend to rise towards 1.

The second caveat for using beta is that it is a measure ofsystematic risk, which is the risk that

the market as a whole faces. The market index to which a stock is being compared is affected by

market-wide risks. So, as beta is found by comparing the volatility of a stock to the index, beta

only takes into account the effects of market-wide risks on the stock. The other risks the company

faces are firm-specific risks, which are not grasped fully in the beta measure. So, while beta will

give investors a good idea about how changes in the market affect the stock, it does not look at

all the risks the company alone faces.

The following is a chart of IBM's stock for the trading period of June 2004 to June 2005. The red

line is the IBM percent change over the period and the green line is the percent change of the

S&P 500. This chart helps to illustrate how IBM moved in relation to the market, as represented

by the S&P 500 during the one-year period.
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Data Source: Barchart.com

On June 8, 2005 the beta for IBM on Yahoo was 1.636, meaning that up to that point, IBM had

the tendency to move more sharply in either direction compared to the S&P 500 - and the chart

above demonstrates IBM's tendency for higher volatility. When the market moved up IBM (red

line) tended to move up more (see the Oct-to-Dec range), and IBM's stock fell more than the

market when it declined (see the Jan-to-Mar range). The large drop in IBM stock from Mar to Apr2005, while coinciding with a smaller drop in the S&P, resulted from a firm-specific risk: the

company missed earnings estimates.

By showing IBM's behavior over this period, this chart demonstrates both the value that comes

with the use of beta and the caution that needs to be shown when using it. It helps measure

volatility, but it is not the whole story.

Conclusion

We hope this has helped shed some light on an often-underestimated financial ratio. Analysts,brokers and planners have used beta for decades to help them determine the risk level of an

investment, and you should be aware of this risk measure in your investment decision-making.


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Beta: Know the Risk

How should investors assess risk in the stocks they buy or sell? As you can imagine, the concept

of risk is hard to pin down and factor into stock analysis and valuation. Is there a rating--some

sort of number, letter, or phrase--that will do the trick?

One of the most popular indicators of risk is a statistical measure called beta. Stock analysts use

this measure all the time to get a sense of stocks' risk profiles. To learn about the basics of beta,

take a look at Beta: Gauging Price Fluctuations. Here we shed some light on what the measure

means for investors. While beta does say something about price risk, it does have its limits for

investors looking for fundamental risk factors.

Beta

Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a

beta of 1.0, and individual stocks are ranked according to how much they deviate from the

market. A stock that swings more than the market over time has a beta above 1.0. If a stock

moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to

be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower

returns.

Beta is a key component for the 'capital asset pricing model' (CAPM), which is used to calculate

cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the

present value of a company's future cash flows. All things being equal, the higher a company's

beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the

present value placed on the company's future cash flows. In short, beta can impact a company's

share valuation.

Advantages of Beta

To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider

when assessing risk. Indeed, 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, which makes it easy to work with. Sure, there

are variations on beta depending on things such as the market index used and the time period
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measured, but broadly speaking, the notion of beta is fairly straightforward to understand. It's a

convenient measure that can be used to calculate the costs of equity used in a valuation method

that discounts cash flows.

Disadvantages of Beta

However, if you are investing in a stock's fundamentals, beta has plenty of shortcomings.

For starters, beta doesn't incorporate new information. Consider the electrical utility company

American Electric Power (AEP). Historically, AEP has been considered a defensive stock with a

low beta. But when it entered the merchant energy business and assumed high debt levels,

AEP's historic beta no longer captured the substantial risks the company took on. At the same

time, many technology stocks, such as Google, are so new to the market they have insufficient

price history to establish a reliable beta.Another troubling factor is that past price movements are very poor predictors 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. But for investors with long-term horizons, it's less useful.

Re-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 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 in regards to the academic community and its

attitude towards value investing: "Well, it may be all right in practice, but it will never work in

theory." Value investors scorn the idea of beta because it implies that a stock that has fallen

sharply in value is more risky than it was before it fell. 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 its future cash flows.
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If you are a fundamental investor, consider some practical recommendations offered by Benjamin

Graham and his modern adherents. Try 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 consistency of growth, in

earnings ordividends. An important one comes from not overpaying. Stocks trading at low

multiples of their earnings are safer than stocks at high multiples

Conclusion

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.
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