Beta the Measure of Volatitlity

Beta is a mathematical construct deeply embedded in academic models of stock valuation.  It’s inherently flawed and investors should understand it. Simply put, the concept of beta makes perfect sense. It’s a measure of a stock’s relative volatility to the market at large.  I will explain why it’s deeply flawed and how investors can take advantage of this to make outsized alpha.

  • beta of 1: This means this stock is in line with the market.  The market usually refers to the S&P 500 group of stocks
  • Beta of less than 1: This means market fluctuations affect this stock to a lesser degree (utility stocks)
  • Beta of more than 1: This means this is a volatile stock (technology stocks)
  • Negative beta: This means that this stock moves in the opposite direction to the market!  If the market’s returns are negative, this stock’s returns will be positive!  Gold is usually given as an example even though beta shows that though it is less than 1, it isn’t negative.
  • Zero beta:
  • This means this stock returns have no relation to the market!  Cash in your wallet for example, or a lottery ticket you just bought

That alls seems logical enough. So what’s wrong with this picture?  Plenty, first, you have to understand how beta is calculated before you can understand how fatally flawed it is. Beta is a backward-looking statistical calculation. The formula for beta is provided by Investopedia

The one thing you see on almost every piece of financial literature and marketing material. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.  We take this disclaimer to be gospel in the financial advisory business. So why is it completely discarded in modern portfolio theory, the bedrock of academic stock valuation models? I don’t have a good answer to this except economics is the dismal science.  We grasp at explaining human behavior with mathematics and beta is the best we can come up with.  If you think just because a stock acted a certain way in the past it will always act this way, you are going to be a very unhappy long term investor.  It may work for a while but one piece of negative news can blow apart most “predictable” chart patterns. Beware beta, it’s only a picture of the past, not the future.

If you do your own research and step away from the crowd, you may discover mispriced beta.  Nowhere is this more apparent than in stock options as they are almost entirely based on the mathematic models of beta, implied volatility.

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