Question

Discuss the use and limitations of Beta and how it is applied as a tool for risk measurement.

Answer 1

Beta is a measure of a stock's volatility in relation to the market. It is used to compute an asset’s expected return in the capital asset pricing model (CAPM). This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market or with a less volatile one.

Uses of Beta

A stock's price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, the beta has appeal as a proxy for risk.

Intuitively, it makes plenty of sense. 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 that discounts cash flows.

Limitations of Beta

• Investing in a stock's fundamentals, the beta has plenty of shortcomings.
• The past price movement is a poor predictor of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.
• Beta measure on a single stock tends to flip around over time, which makes it unreliable.
• 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.

An asset with a beta of one will fluctuate with the overall stock market. Whereas, an asset with a beta higher than one is more volatile than the stock market. An asset with a beta less than one is less volatile than the stock market. In addition, an asset with a negative beta coefficient moves inversely to the stock market.

For example, if a stock has a beta of 1.5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by 15%. (15% = 1.5 x 10%). If a stock has a beta of .5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by only 5%. (5% = .5 x 10%). If a stock has a beta of -1, and the return on the overall stock market rises by 10%, then the return on that stock is expected to decline by 10%. (-10% = -1 x 10%).