A brief description of why I think Beta values are misused.
Frequently when talking about investment returns, an individual will be confronted by a high brow academic with the question: “Yes that’s all very good, but what’s your RISK ADJUSTED return?” This question is usually followed by smirk or a fist bump to his other MBA buddies.
Investopedia describes Risk Adjusted Return as: A concept that refines an investment's return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating.
While there are many ways of quantifying the risk involved in an investment, the Beta value is probably the most popular.
Investopedia explains Beta
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
Investopedia accurately describes both beta and risk adjusted returns and illustrates perfectly my first problem with the use of beta values. I agree that beta values provide a measure of a stocks tendency to respond to moves in the market, I disagree that this translates directly into risk.
Before we get into a semantics argument about the meaning of risk, let me lay out my definition as it applies to investing.
Risk is the magnitude weighted probability that you will receive below average returns on an investment.
Lets use the market in 2009 as an example. By March of 2009 high beta stocks were significantly undervalued because as the market fell through 2008, these stocks tended to fall faster. Then starting in March as the market recovered these stocks far outperformed the market as they had more ground to recover before reaching a “fair” market value. This time period clearly showed the positive or negative impact that high beta stocks could have on your returns. But does it indicate that high beta stocks carried increase risk? The results of myself and others have been downplayed with the argument that “anyone can be a hero who picked high beta stocks in March”. If you see the beta value for what it represents, you see that this argument is as foolish as saying “anyone can be a hero who accurately identifies highly undervalued companies”. The trick isn’t to pick high beta stocks, it’s to pick high beta stocks at the right time. I would actually go one step further to say that the true trick is consistently pick undervalued stocks regardless of the time.
My second problem with beta values is that they correlate the historical price of a stock with a historical market index. Besides the parallels this has with TA, as a risk measurement is lacks any fundamental component. In my opinion, the real risk an investor has when buying a stock is that the company will not generate the free cash flow the investor planned on. I would suggest a better risk measurement would be a correlation between free cash flows and the market index. Essentially identifying how sensitive the company’s income generation is to broad market movement.
In conclusion, I believe Beta values provide investors exactly what they measure, and idea of how the stock has historically moved with the market. I think they are inadequate as a measure of risk because they utterly fail to consider the fundamentals, or the position of the market.
I welcome any feedback or comments.