How should investors assess risk in the stocks that they buy or sell? While the concept of risk is hard to factor in stock analysis and valuation, one of the most popular indicators is a statistical measure called beta. Analysts use it often when they want to determine a stock's risk profile. However, while beta does say something about price risk, it has its limits for investors looking to determine fundamental risk factors.

What Is Beta?

Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market, such as the S&P 500 Index, 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 higher return potential; low-beta stocks pose less risk but also lower returns.

Key Takeaways

  • Beta is a concept that measures the expected move in a stock relative to movements in the overall market.
  • A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
  • Beta is a component of the Capital Asset Pricing Model, which calculates the cost of equity funding and can help determine the rate of return to expect relative to perceived risk.
  • Critics argue that beta does not give enough information about the fundamentals of a company and is of limited value when making stock selections.
  • Beta is probably a better indicator of short-term rather than long-term risk.

Beta is a component of the capital asset pricing model (CAPM), which is used to calculate the cost of equity funding. The CAPM formula uses the total average market return and the beta value of the stock to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. In this way, beta can impact a stock's expected rate of return and share valuation.

Calculating Beta

Beta is calculated using regression analysis. Numerically, it represents the tendency for a security's returns to respond to swings in the market. The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period.

Beta=CovarianceVariance\text{Beta} = \frac{\text{Covariance}}{\text{Variance}}Beta=VarianceCovariance

The Advantages of Beta

To followers of CAPM, beta is useful. A stock's price variability is important to consider when assessing risk. 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 that is easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured. But broadly speaking, the notion of beta is fairly straightforward. 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."

Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is riskier 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 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.