The stock market is a good investment when taken as a whole; In any given period longer than three years, historically speaking, the chances are high that you’re going to come out on top, provided you invest in the whole market. Picking individual stocks, however, is much more risky.
Enter beta. Beta is the coefficient used to measure the volatility and risk of a specific stock. The higher the beta coefficient, the greater the risk of investment. For example, treasury bonds have a very low beta, whereas stocks with prices all over the place have a very high beta. In practice this means that t-bonds have a very low risk, but also a very low reward. In comparison, our theoretical, highly volatile stock with lots of peaks and troughs offers a high reward at a very high risk.
Now for the number itself: A stock’s beta coefficient isn’t picked out of the clear blue sky. Instead, its based on objective formulations. Put simply, a stock with a beta of 1.0 moves up and down, but at precisely the same rate as the overall market. On the other hand, a stock with a very high beta of 4.5 moves up and down much more than market average. What’s more, investments like t-bonds and cash have betas of zero or close to, meaning that they typically carry limited risk as compared to the rest of the market.
The concept of beta isn’t without its critics. Seth Klarman, founder of Boston’s Baupost Group has called the concept that past fluctuations provide a neat, quickly digestible, single-number summary of risk “preposterous.” Indeed, in some sense, picking stocks based on past fluctuations can be a bit like trying to bet on next year’s Super Bowl based on last year’s winner; There are far more factors in play than how a stock performed in the past.
A historical example of the limitations of beta is the tech boom of the 1990s. Prior to the tech boom, investing in start-ups would likely have been considered a poor investment. What’s more, during the boom, tech stocks had a very low beta, because the overall trend was up. But when the bubble burst and markets tumbled, tech stocks were hurt much worse than the rest of the overall market, despite their lower beta coefficient.
Perhaps a more useful concept is the concept ofsmart beta. Basically, this is a type of calculated risk. Researchers discovered that inexpensive, “high-risk” stocks could actually outperform the overall market. This is because the market had a tendency to punish stocks too harshly with unduly low prices. In a sense, this made these stocks a bit like money laying in the street.
These are good picks for long-term investors, but not for short-term gains. Rather than performing on a three-year time table, stocks attractive due to smart beta require a minimum of five-year investment. In the hands of a skilled manager, however, smart beta stocks can be an attractive investment.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.