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In my last post I discussed an investment metric known as alpha. Alpha is a gauge of risk-adjusted returns provided by a portfolio manager. Alpha isn’t the only measure of a stock or portfolio’s risk profile. Another one is called beta. Beta measures a stock’s volatility in comparison to the overall market. A beta value of 1 is assigned to the overall market. So a stock that has a beta of one would be considered to move in lockstep with the overall market. If the market were to go up by 10%, the stock should also move by the same amount in the same direction.
A stock that moves less than the overall market would have a beta less than one. A beta greater than one indicates a stock that moves in the same direction as the overall market but in more extreme swings. Beta can be a good figure to use in rule-of-thumb investment decisions but it does have one serious drawback of which investors should be aware. Beta is calculated based on historical price movements relative to the market. Because of this method of calculation it doesn’t take into account any new information about the underlying fundamentals of the company. Due to this limitation, beta should never be used in a vacuum.
Remember, statistics like alpha and beta can provide guideposts to help you evaluate an investment manager or the risk of a particular stock but they shouldn’t be relied upon to replace the hard work of fundamental analysis. It is the key things going on with a company’s balance sheet and income statement that are the true underpinnings of the stock’s valuation. Keep this in mind when evaluating stocks or portfolios and you’ll be in good shape.
I’m not saying that statistics like alpha and beta should be ignored; they’re great tools. Just don’t let them be the only tools you use when making investment decisions.
