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BULLS & BEARS: Beta as a measure of risk only one factor to consider

March 14, 2005

The field of investing is constantly generating massive amounts of data that is readily compiled, measured and analyzed. Historical stock price movements are spun into charts, figures from financial statements are manipulated into ratios, and computer software allows the calculation of all sorts of esoteric statistics.

Perhaps to no one's surprise, the ease with which numbers can be mathematically massaged can often produce misleading results. As a wise prophet once said, "To a man with a hammer, everything looks like a nail."

In the academic world of finance, one statistical measure that figures prominently in financial models is called "beta," which is purported to define the risk of an investment.

For any particular stock, its beta is determined by how volatile the stock price has been in relation to the overall stock market. For example, the aggregate stock market has a beta of 1.0. Now, consider a stock that has hopped around in price, both up and down, in greater percentages than the stock market.

Skipping the actual math formula, let's say this particular stock has a calculated beta of 1.5. This number, according to the academics, tells us this stock is considered 50-percent riskier than the stock market as a whole. And, in their theories, if the overall stock market were to rise 10 percent, a stock with a beta of 1.5 would rise 15 percent (10 percent x 1.5). Conversely, if the market were to decline 10 percent, the high beta stock would decline 15 percent.

It probably would strike even the most casual investor as a silly notion that the combined elements of risk inherent in any stock can be boiled down to a single numerical value.

In addition, the belief that volatility is a proper measure of risk is faulty. Consider the following: Under beta-based theory, a stock that has dropped sharply in relation to the overall stock market becomes "riskier" at the lower price than it was at the higher price. The idea that it is somehow riskier for an investor to acquire a stock at a significantly reduced price makes little sense.

In fact, volatility can actually create attractive investment opportunities for a long-term investor. In a volatile stock market, irrational (undervalued) prices will often be attached to attractive businesses.

The attempt to measure risk based on historical stock price movements (beta) ignores some of the subjective risks in a business that a "thinking" investor might assess. Items such as the long-term economics of the business, what its competitors are doing, or how much borrowed money the business uses.

By focusing on the characteristics of a business, a reasonably intelligent, informed and diligent person should be able to judge investment risks with a useful degree of accuracy.

In the end, the academic theory of beta derived from the movement of stock prices is a poor corollary for risk. Instead, we would guess that most investors would simply define risk as the probability of losing money.

Unfortunately, too many investors become concerned with risk only after they lose money. For an investor, it is imperative to be conscious of the potential risks in an investment, particularly during the good times.



Ken Skarbeck is managing partner of Indianapolisbased Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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