Inflation could still dampen returns for stocks if bond yields start climbing steadily. Real wages adjusted for inflation have also slipped lately, making it tougher for consumers to buy more of anything. Overall, the bull market is clearly intact as the economic recovery continues. But investors may become more selective towards stocks if the rising price environment persists, and favor those of companies with the capability of consistently passing along rising costs.
At the time of this writing, the author did not have positions in any of the companies mentioned in this article. You may be able to find a stock or fund's beta financial data sites. However, you may want to see what the site uses as a benchmark and the period it uses when calculating the stock's beta.
Beta can be particularly important for investors who might not want to have their portfolio make big swings. And for investors who may need the money in the short-run and wouldn't have time to recover if there's a quick downturn.
The same should be done for beta. While the beta coefficient measures a non-diversifiable risk, you can protect against large swings in your overall portfolio by choosing investments that have negative, low, moderate, and high betas.
Keep in mind that a stock could have a volatile price and still have a low beta if the volatility isn't correlated with changes in the market. Also, because beta is based on historical returns, an asset's beta may change over time. While beta measures how an investment may change with the market, alpha measures how well an investment performs relative to the market. They can be used together when researching investment opportunities. Beta is actually a vital component of the capital asset pricing model CAPM.
The CAPM formula can be used to estimate the expected return of an asset based, in part, on its beta. This can then be compared to the asset's actual return to see if it generated alpha — or beat its benchmark without taking on additional risk. It could be important to consider alpha and beta in tandem when you're reviewing investment opportunities. Bortnem shares a simple example of why:.
Predicting how much an investment — or your entire portfolio — may move when the market is up or down can be an important component of investing. 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. 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. 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.
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