Understanding the Beta Coefficient

by Jason Jenkins

Understanding beta and its limitations

There's a deluge of statistics that are listed for stocks on sites like Yahoo! Finance and Google Finance. And one of those metrics listed front and center is the beta coefficient, or “beta.” Some investors may be familiar with the fact that beta is a metric that is supposed to imply risk.

But it's a definite must for investors to know the distinction between short-term risk – where beta and the concept of price volatility are useful – and longer-term, fundamental risk where economic and corporate risk play a larger role.

High betas may mean price volatility over the near term, but they don't have to necessarily rule out long-term opportunities. While beta does say something about price risk, it does have its limits for investors looking at fundamental risk factors.

What is the Beta Coefficient?

  • Beta is a measure of a stock's volatility in relation to the overall market.
  • 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 coefficient 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.

In other words, volatility refers to the amount of uncertainty or risk about the degree of changes in a stock's value. A higher volatility means that a stock's value can potentially be spread out over a larger range of values.

This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security's value does not fluctuate dramatically, but changes at a steady pace.

The beta coefficient is a key component for the Capital Asset Pricing Model (CAPM), which is used to calculate cost of equity. The Capital Asset Pricing Model describes the relationship between risk and expected return and that is used in the pricing of risky securities.

In simpler terms, the idea behind CAPM is that investors need to be compensated in two ways:

  • The time value of money – Money could be earning interest in a risk-free investment like a U.S. treasury. Therefore you must be earning more than this rate for an investment to be worthwhile. (Rates usually aren't this low…)

  • Risk – For an investor to take on more risk there must be more reward.

So in the academic investing world beta offers a clear, quantifiable measure, which makes it easy to work with.

Where Beta Loses its Luster

But there are three major reasons the beta coefficient can fall short in applications for an average investor:

  • Beta doesn't incorporate new information. We have all seen that new knowledge regarding economic, political, industry or corporate factors can have a tremendous affect on a stock.

  • Past price movements are very poor predictors of the future. Betas are pretty much just reflective pools of the past. They do nothing to tell you what's ahead.

  • Betas on a single stock tend to flip around over time, which makes it unreliable. If you're day-trading, beta is a fairly good risk metric. But for investors with long-term horizons, it's less useful.

The Bottom Line

We investors see risk as the possibility of suffering a loss, so when we consider it, it's in terms that our investment will decrease in value. The concept of beta doesn't think that way – it does not distinguish between upside and downside price movements.

For most investors, downside movements are risk while upside ones mean opportunity. The beta coefficient doesn't help investors tell the difference. And, to the average investor, that's not too sensible.

Good Investing,

Jason Jenkins

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