Investing in the stock market doesn’t have to be stressful or complicated. Invest for the long term in low cost, broadly diversified index funds. This passive strategy beats 80% of active investing strategies that incur way higher fees and taxes. However, new active strategies appear all the time. Understanding these concepts is important so you can feel confident to stick with your simple (and better) strategy. One such concept is beta. So this post is going to be all about understanding beta and its role in the stock market.
A refresher on risk
In the stock market as in much of life, with greater risk comes greater reward. In investing, this makes sense. Why would anyone agree to take on a more risky investment if a higher potential return wasn’t in order? This is why people still go to casinos.
The name of the game then becomes, “How can I minimize risk while maximizing returns?”
The answer over the long run is and continue to be the same, boring old strategy: index funds.
But this hasn’t stopped Wall Street from trying to find another answer. Or at least from trying to convince us, the investors, that it has found another answer.
Anyway, that’s my own aside. Back to risk.
Risk in the stock market comes in two forms…
Systematic and unsystematic risk
First, unsystematic risk
Imagine you own stock in a computer chip company that uses a specific mineral to make the chips (this is the extent of my technological knowledge).
If that mineral becomes more scare and less available, that chip company can’t make as many chips. And your stock goes down.
But now imagine that you owned stock in the mineral harvesting company. Their stock would go up if the mineral became more scarce. And vice versa is the mineral became more widely available.
By owning both of these stocks instead of just one, you can minimize your overall risk and maximize/optimize return.
This is basically why diversification works. In stock market terminology, the risk that can be diversified away is called unsystematic risk.
Meanwhile, systematic risk…
…is risk that cannot be diversified away. This is also called the market risk. This systematic risk captures the reaction of stocks or collections of stocks (mutual funds) to general market swings.
While all stocks tend to go along with the movement of the overall market, some stocks (or collections thereof) will react wildly to general market ups or downs. Some will react more stoically.
Put simply, some stocks are more sensitive than others.
And this brings us to beta in the stock market
Beta is the name assigned to the measurement of a stock’s (or a collection of stocks’) movements compared to the movements of the entire stock market.
For instance, a beta of 1 is the standard. A stock with a beta of 1 would move exactly on par with the overall market.
Meanwhile, a stock with a beta of 2 would swing twice as far (up or down) as the overall stock market. It is more volatile.
A stock with a beta of 0.5 moves up or down half as much as the overall market. It is more stable.
So, beta is a measurement of volatility and systematic risk within the stock market.
So why do we care to measure beta in the stock market?
The reason goes back to the relationship between risk and reward. Remember, potential reward or returns should go up with increase risk.
But is unsystematic risk can be easily diversified away, then it doesn’t make sense that investors should get rewarded for it.
Therefore, because systematic risk cannot be diversified away, that is the risk that we should be compensated to take, in theory. And beta measures this risk. Higher beta, higher theoretical return.
And, while past performance does not equal future performance, we can estimate beta based on past stock movements compared to the overall market.
Beta essentially puts a number on the subjective volatility of a stock in the market. And the economic theory that encapsulated beta and its impact is known as the capital-asset pricing model.
But now for the really important question…
Does a stock market portfolio of higher beta stocks actually give higher returns?
After all, this is the whole idea.
Well, the answer appears to be “no.” A study by two authors, Fama and French, compared average monthly return for stocks against their beta from years 1963 to 1990.
If the beta theory was correct, we would expect a positive correlation between the returns and the increasing beta. But this is not what was found.
In fact, there was no relationship between stocks and their beta risk measurements.
Does this mean that beta is useless?
No, not really.
It does mean that beta did not provide a better way to minimize risk and maximize return. Investing in low cost, broadly diversified index funds still reign supreme in that regard.
But, beta can be useful. For instance, the Fama and French study show that stocks or funds with low beta can do as well as those with high beta. So, finding low beta funds can be very useful is you are going to buck the broadly diversified index fund recommendation.
Also, as noted by Burton Malkiel, it can be very difficult to actually measure beta with precision. And the outcomes found really depend, like anything, on how you measure it. Perhaps a future beta measurement will do better?
In the end
Beta can not be relied upon as a predictor of long term future returns in the stock market.
You can also review my actual stock portfolio here!
What do you think? Do you use beta in your investing strategy? How do you measure it? Let me know in the comments below!