According to the CAPITAL ASSET PRICING Theory (Prof. Merton Miller of MIT), stocks should be priced according to how they move relative to the market as a whole. beta is a measure of this. Anyway, I just checked my portfolio, and my shares have beta ranging from -.67 to +1.85. My question: can you select a winning portfolio based on beta alone? If so, who needs analysts?-just pick high beta stocks, and hold them! What is the flaw in my reasoning?
According to Morningstar,
The article goes into some detail, which I’ll leave as an exercise to the reader , but to summarize: a stock fund’s beta is usually measured against the S&P500. Such a fund with a beta of 1.1 would gain 11% for every increase of 10% in the S&P500, but it will also lose 11% for every decrease of 10% in the S&P500.
On the face of it, your reasoning is OK, assuming the stock market continues to rise (which it probably will, long-term). Just be sure that you understand your statistics.
Morningstar on the web has some really good educational resources.
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That’s what I thought. Beta measures the riskiness of an investment, relative to a benchmark. The higher the beta, the better it will do when the benchmark is increasing, but the worse it will do when the benchmark decreases.
Well, no. Beta measures how volatile a (stock, mutual fund, whatever) has been relative to the comparative benchmark, not how it’s going to perform. High beta stocks as a group have tended to behave as you describe, but when one gets down to the single stock (or fund) level, things get more complicated.
A stock that has gone only up will show a high beta relative to an index that has moved up and down. Unfortunately, a stock that’s gone only down will also show a high beta relative to the same index.
I’ll pull out the Miller and give a better, longer discussion of beta in CAPM when I have a chance, probably this weekend.
Livin’ on Tums, Vitamin E and Rogaine
Manhattan is correct. Beta specifically measures only volitility (and only historical volitility at that.)
If you picked a portfolio of high volatility stocks, all you could reasonably expect would be a great deal of fluctuation, and this only as compared to the underlying index from which you derive your Beta.
What about the stocks that show negative beta? Is it possible to construct a picking strategy for these? Wouldn’t a negative beta portfolio be a good one to short?
No:
Beta measures volatility, not perfomance.
A short portfolio of low beta stock is not likely to change in value very much. You lose on the margin interest.