Breaking News
Investing Pro 0
Cyber Monday Extended SALE: Up to 60% OFF InvestingPro+ CLAIM OFFER

Beta Is A Useful Risk Metric, If You Use It Correctly

By James PicernoMarket OverviewNov 24, 2020 08:19AM ET
www.investing.com/analysis/beta-is-a-useful-risk-metric-if-you-use-it-correctly-200545693
Beta Is A Useful Risk Metric, If You Use It Correctly
By James Picerno   |  Nov 24, 2020 08:19AM ET
Saved. See Saved Items.
This article has already been saved in your Saved Items
 
 
VTI
+3.08%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
VWO
+2.71%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
VNQ
+2.29%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 
VNQI
+1.10%
Add to/Remove from Watchlist
Add to Watchlist
Add Position

Position added successfully to:

Please name your holdings portfolio
 

In a world awash in identified risk factors, the original quantitative profile of investment risk long ago fell from grace. If you spend ten minutes on the internet searching for research that finds beta to be irrelevant, at best, you’ll quickly line up reading material for a month. But the majority of the criticism focuses on beta’s weakness for parsing individual stocks. By that standard, beta suffers several well-known and reportedly fatal flaws as a risk measure. But applied to asset classes in the context of portfolio design and management, beta’s far from dead.

Beta, of course, is the risk metric in the capital asset pricing model (CAPM) and quantifies the relationship between an investment and the portfolio. A beta of 1.0 indicates that an investment’s risk profile matches the market portfolio’s risk. Higher (lower) betas equate with relatively higher (lower) risk.

As numerous studies over the years have shown, beta has minimal, if any, value for analyzing individual stocks. A key issue: low-beta shares tend to outperform high-beta shares. Not good if you’re expecting beta to proxy for risk. Therein lies the basis for the success of low-volatility equity portfolios, which violates CAPM’s logic.

Beta’s track record is wobbly at best for stock portfolios, but the risk metric looks better for multi-asset-class strategies. Perhaps that’s not surprising since CAPM is focused on the “market” portfolio, which in theory holds all assets. By that standard, trying to use beta and CAPM in an equity-only context is asking for trouble.

As a toy example, consider how beta and return compare for the major asset classes, based on a set of proxy ETFs:



The chart below plots these ETFs for beta vs. trailing 5-year annualized total return. The relationship isn’t perfect, but there’s a general connection between risk and return a la CAPM. Higher return tends to align with higher return.

Return Vs Beta Trailing 5 years
Return Vs Beta Trailing 5 years

To be fair, beta only captures a piece of the risk profile. If it was a perfect risk metric and told you everything you needed to know about risk, all the blue squares in the chart above would line up directly on the red line, which reflects the regression for return vs. beta. Unfortunately for investors, the real world is messy and so beta’s imperfect. But that’s a long way from saying beta’s irrelevant or useless. Indeed, if we limited our analytics to risk metrics that were 100% perfect, we’d be left with nothing.

One of beta’s uses is helping us identify outliers – markets that may be unusually overbought or oversold, a.k.a. as markets that aren’t in equilibrium, to use the language of CAPM.

In the long run, the CAPM probably holds. If so, short-run cases of dis-equilibrium reflect useful bits of market intelligence.

With that in mind, running beta analytics over shorter periods can help us put a multi-asset class portfolio into sharper focus from a tactical perspective. For instance, the next chart below shows how the ETFs listed above stack up for return vs. beta over the trailing 120-trading-day period.

Return Vs Beta Trailing 120 days
Return Vs Beta Trailing 120 days

Looking at the two charts implies that US stocks (VTI) and emerging-markets stocks (VWO) have been running hot lately. Meanwhile, US REITs (VNQ) and foreign real estate (VNQI) have been relatively weak.

In theory, all the funds will align at or close to the red line through time, which implies that relatively large deviations from this point of equilibrium reflect opportunities for tilting weights in a multi-asset-portfolio strategy (or at least assets that deserve closer inspection).

Beta is only one tool in the toolkit and shouldn’t be used in isolation and the charts above represent the a simple example of a first step for this line of research. Meantime, every risk metric is flawled, which means that we should analyze markets from multiple perspectives using a range of quantitative (and perhaps qualitative) measures. But in assembling your toolkit, don’t be too quick to throw out beta. To paraphrase George Box’s famous quote about models, all risk metrics are wrong, but some are useful.

Beta Is A Useful Risk Metric, If You Use It Correctly
 

Related Articles

Lance Roberts
One Monetary Policy Fits All By Lance Roberts - Nov 30, 2022 3

With an understanding of the dollar’s role as the world’s reserve currency, it’s time to discuss how the Federal Reserve’s monetary policy machinations influence the dollar and,...

Beta Is A Useful Risk Metric, If You Use It Correctly

Add a Comment

Comment Guidelines

We encourage you to use comments to engage with other users, share your perspective and ask questions of authors and each other. However, in order to maintain the high level of discourse we’ve all come to value and expect, please keep the following criteria in mind:  

  •            Enrich the conversation, don’t trash it.

  •           Stay focused and on track. Only post material that’s relevant to the topic being discussed. 

  •           Be respectful. Even negative opinions can be framed positively and diplomatically. Avoid profanity, slander or personal attacks directed at an author or another user. Racism, sexism and other forms of discrimination will not be tolerated.

  • Use standard writing style. Include punctuation and upper and lower cases. Comments that are written in all caps and contain excessive use of symbols will be removed.
  • NOTE: Spam and/or promotional messages and comments containing links will be removed. Phone numbers, email addresses, links to personal or business websites, Skype/Telegram/WhatsApp etc. addresses (including links to groups) will also be removed; self-promotional material or business-related solicitations or PR (ie, contact me for signals/advice etc.), and/or any other comment that contains personal contact specifcs or advertising will be removed as well. In addition, any of the above-mentioned violations may result in suspension of your account.
  • Doxxing. We do not allow any sharing of private or personal contact or other information about any individual or organization. This will result in immediate suspension of the commentor and his or her account.
  • Don’t monopolize the conversation. We appreciate passion and conviction, but we also strongly believe in giving everyone a chance to air their point of view. Therefore, in addition to civil interaction, we expect commenters to offer their opinions succinctly and thoughtfully, but not so repeatedly that others are annoyed or offended. If we receive complaints about individuals who take over a thread or forum, we reserve the right to ban them from the site, without recourse.
  • Only English comments will be allowed.

Perpetrators of spam or abuse will be deleted from the site and prohibited from future registration at Investing.com’s discretion.

Write your thoughts here
 
Are you sure you want to delete this chart?
 
Post
Post also to:
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Thanks for your comment. Please note that all comments are pending until approved by our moderators. It may therefore take some time before it appears on our website.
 
Are you sure you want to delete this chart?
 
Post
 
Replace the attached chart with a new chart ?
1000
Your ability to comment is currently suspended due to negative user reports. Your status will be reviewed by our moderators.
Please wait a minute before you try to comment again.
Add Chart to Comment
Confirm Block

Are you sure you want to block %USER_NAME%?

By doing so, you and %USER_NAME% will not be able to see any of each other's Investing.com's posts.

%USER_NAME% was successfully added to your Block List

Since you’ve just unblocked this person, you must wait 48 hours before renewing the block.

Report this comment

I feel that this comment is:

Comment flagged

Thank You!

Your report has been sent to our moderators for review
Continue with Google
or
Sign up with Email