BETA

This is a reflection of the risk of a particular stock or mutual fund to the market overall. It is determined by dividing the standard deviation of the security by the standard deviation of the market overall and then multiplying by the correlation coefficient of that investment to the market. If the deviation of the security was 16%, the deviation of the market was 13% and correlation was .7, Beta for the stock would be .86. That essentially means that if the market went up 1, this stock would only go up 86% of that.

A simpler method in "accurately" determining beta is to simply look at the movement of the stock or fund versus an index over a period of time- say one year. The volatility comparison is a realistic gauge as to how it might move in the near term. Over the long term however, as with most statistics, the volatility might change and it therefore should be monitored on an ongoing basis.

A long held theory that stocks with greater volatility- those with betas greater than 1- supposedly outperformed less volatile stock- betas less than 1. However, A University of Chicago study of thousands of stocks over 50 years now says it makes little, if any, difference. They did note that stocks with high book values relative to their stock market price did better than stocks with low book values relative to market price. Also, they confirmed that small companies tend to do better than large cap stocks.

A further comment from Bodie, Kane and Marcus notes that betas estimated from past data may not necessarily reflect the best estimates of future betas and that betas tend to drift toward 1 over time (hence the correlation with the Chicago study above). They suggest that current beta should be a reflection of past beta, firm size, debt ratio, variance of earnings, variance of cash flows, growth in earnings per share, market capitalization, dividend yield, debt to asset ratio and other ratios as well.

And from MacQueen, Jason and Stern in The Revolution in Corporate Finance, 1986, "the fact of the matter is that betas do work, more or less well depending mostly on how sensible we've been in calculating them. All betas are relative to one or another market proxy. Naturally, something's beta will change if its is measured against different market indices. The point is that it has to be measured against something, and it is therefore up to the user to decide which market proxy is most appropriate".

The formula for beta

( (N) (Sum of XY) ) - ( (Sum of X) (Sum of Y) ) / [(n) (sum of (xx)) ]-[ (sum of x) (sum of x)]

Where N = the number of observations

X= rate of return for the S&P 500 Index

Y = Rate of return for stock or fund.

In summary, there probably should not be a wholesale reliance on beta as the only criteria used to determine the risk of a stock or portfolio. And certainly it loses viability when looking too far to the future or where you are comparing completely different types of funds to each other (gold versus S&P 500) since there may be too many other factors invovled. However, in the short time frame, and certainly for current review, it is a valuable number in comparing one major element of risk to that of other indices. Further, almost all rating services use either beta directly or something very similar- see Value Line, Morningstar, Lipper, etc. Every investor must know about beta.

Where is beta going ? the riskiness of value and small stocks (Franzoni, Francesco 2007) This paper finds that the market betas of value and small stocks have decreased by about 75% in the second half of the twentieth century. The decline in beta can be related to a long-term improvement in economic conditions that made these companies less risky.