Just like Wednesday, I’m on a statistics kick. And like I told you yesterday, beta deserves its own post. Beta is an interesting measure that you’ll often find listed among stock quotes. But what is it?
Before we start I must warn that while the first half of this post is a simple explanation, the second half gets kind of math heavy.
Beta is basically a correlation of a stock’s return to the market’s return. So if Morgan Stanley had a beta of 1 this means that (on average) when the S&P 500 goes up 1%, Morgan Stanley does too. If the beta is 2, Morgan Stanley would go up 2% for every 1% increase in the market. Conversely, when the market goes down 1%, Morgan Stanley would go down 2%. Just so we all know, the beta of Morgan Stanley according to Google Finance on October 8 is 1.38.
So we understand what beta is, but what do we use it for? Well imagine you managed investments for a mutual fund. You’re finding that the current market conditions are too volatile for you. The S&P 500 is swinging more than a 10-year old going for the distance jump off the jungle gym. The overall beta of the stock you’re holding is 1.1, so to avoid all the stresses in the movements, you seek out stocks to make the overall beta of your portfolio 0.75. Now when the S&P moves 1% your portfolio just moves 0.75%. This stability in uncertain markets keeps your shareholders happy.
Or pretend you’re managing a hedge fund. You own a number of stocks but want to own some investments that don’t move so much with the market. Perhaps it’s real estate or bonds, it doesn’t matter. These investments do not rely on the stock market for their returns and will have low betas. Bonds, strictly speaking, have a beta of zero with the market.
But what does the beta mean to the average investor? Do you think your investments are well diversified to protect you from losses? Ask your investment manager to tell you the beta of your portfolio compared to the S&P 500 over the last 5 years. If he can’t then get a new manager. If the beta comes back 1 or higher then you are relying on the market for your returns and are not protected against a down market. That isn’t a bad thing if you’re tolerant to risk, the beta on my 401(k) is 1.3. I calculated it myself. If you want to know how then read on. If not then we’re done for today and have a great weekend!
Remember back in high school when you were graphing equations? If you were an ass like me then you raised your hand and asked when on earth we’d ever use this outside of class? Well, does this look familiar?
y = mx + b
y is an independent value, x is dependent, and b is the y-intercept. In other words, to define y, we need to know the slope of the line and the value of x and the point on the y axis where the line will hit.
Well in finance we can rewrite this same formula as:
re = a + b(rm)
Stick with me for a second and you’ll feel better. re is the return on an equity, in our case the return on Morgan Stanley stock. a is alpha*, it’s the y-intercept. rm is the return on the market, in this case, the S&P 500. b is beta, in the linear equation it’s the m. In other words, if you were to plot the returns of Morgan Stanley and the S&P 500 on a chart like the one below and draw a line that best fits, the slope of that line would be the beta.
So how do you solve for the beta? You only need two things. You need your choice of daily, weekly, monthly, or yearly returns on your choice market and choice stock (or portfolio). You can do about a half-dozen things with this data in excel. If you know how to run a regression, do that with the equity as the dependent variable. The coefficient is the beta and the intercept is the alpha. You can also use the “slope” function or if you’re feeling lucky divide the covariance of the market and the equity by the variance of the equity and multiply by n/(n-1). n is the count of data you have. If you were using the daily data for the month of October, n = 31.
Beta is an amazing tool for investors, even those of us just looking at our retirement portfolios. Though I used Morgan Stanley as a reference, don’t think you should start looking for stocks based on beta. Keep your eyes on the long term prize, and just drop your investment knowledge at your next party.
*so your head won’t explode on a Friday, I’m not going to explain what alpha is. Google it, but don’t bother unless everything I’ve said here today made PERFECT sense.
 By The Weakonomist |
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Beta is an amazing tool for investors, even those of us just looking at our retirement portfolios.
I mean no personal offense, but I think it is pure silliness.
If you buy stocks at good prices, you will do well in the long term. If you buy stocks at poor prices, you will do poorly in the long term.
If you spend too much of your time looking at things like beta, you are more likely to take your eye off the ball and persuade yourself that there is some justification for ignoring price.
Lots of people who study things like beta until their eyes bleed don’t possess a strong understanding of how stock investing works, in my assessment. My view is that this is the sort of thing that looks good on chalkboards but doesn’t pay off in the real world.
Rob
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