Is beta a useful risk management or leveraging tool for investors? Two May 2009 articles, “Beta = 1 Does a Better Job than Calculated Betas” by Pablo Fernandez and Vicente Bermejo and “Betas Used by Professors: A Survey with 2,500 Answers” by Pablo Fernandez, address this question by testing the reliability of beta measurements over time, across calculation methods and across data sources. Focusing on betas for the Dow Jones industrial stocks relative to the S&P 500 index, these articles conclude that:
- Different sources provide very different values of beta. For example, values of beta as of May 12, 2009 from sources frequently cited by finance and economics professors in survey responses vary from:
- 0.31 to 0.80 for Coca Cola
- 0.72 to 1.39 for Walt Disney
- 0.13 to 0.71 for Wal-Mart
- Betas calculated from historical data based on a “standard” method vary considerably on a daily basis (see the first chart below).
- Betas calculated from historical data vary considerably with the length of the historical interval (e.g., three years or five years), frequency of return measurement (e.g., monthly or weekly or daily) and reference index used (see the second chart below).
- Even when constrained to a specific calculation method, betas for different stocks can vary considerably with respect to each other. One cannot consistently determine with confidence that the beta for one stock is higher than the beta for another.
- Over the period 1989-2008, a constant beta=1 generally yields higher correlations of individual stock returns with S&P 500 index returns than do unique stock betas calculated from historical data for all but two of the Dow Jones industrial stocks.
- Beta does not consistently relate to other measures of risk.
The following chart, taken from the paper, plots the betas for Coca Cola, Walt Disney and Wal-Mart for each trading day of April 2009 with respect to the S&P 500 index based on five years of monthly data. It shows that beta calculated via this “standard” method can vary considerably over very short periods.
The next chart, also from the paper, plots the betas for Coca Cola for each trading day of April 2009 with respect to the S&P 500 index based on five years of monthly, weekly and daily data. It shows that betas calculated with different return frequencies have very different values and variabilities.
In summary, stock betas calculated from historical data vary considerably over short intervals, across calculation methods and across data sources and therefore may be of little or no value as an investment tool.
Frequently Asked Questions
What is beta in finance and how is it used to measure stock risk?
Beta in finance is a measure of a stock's sensitivity to market movements, typically calculated relative to an index such as the S&P 500. It is commonly used as a risk management and leveraging tool for investors. The article tests how reliable beta is for this purpose using Dow Jones industrial stocks.
Is calculated beta a reliable predictor of stock behavior compared with assuming a beta of 1?
Calculated beta is generally not more reliable than assuming a constant beta of 1. Over 1989-2008, beta=1 yielded higher correlations of individual stock returns with S&P 500 returns than stock-specific historical betas for all but two Dow Jones industrial stocks. The article concludes beta may be of little or no value as an investment tool.
How is stock beta calculated from historical data and what choices change the result?
Stock beta is calculated from historical returns relative to a reference index, such as the S&P 500 in the article's tests. The result varies with the length of the historical interval (e.g., three or five years), the return frequency (monthly, weekly or daily) and the reference index used. The article showed that beta from five years of monthly data can swing considerably from one trading day to the next in April 2009.
Why do different sources report different betas for the same stock?
Different sources report different betas for the same stock because they use different calculation methods, historical intervals, return frequencies and reference indexes. As of May 12, 2009, reported betas ranged from 0.31 to 0.80 for Coca-Cola, 0.72 to 1.39 for Walt Disney and 0.13 to 0.71 for Wal-Mart. Even within a single method, the relative ranking of betas across stocks was not consistently reliable.
What are the limitations of using beta to compare the risk of different stocks?
Beta has limited usefulness for comparing stock risk because it is unstable over short periods, differs across calculation methods and data sources, and does not consistently relate to other risk measures. Even with a fixed method, one cannot confidently determine that one stock's beta is higher than another's. The findings are based on Dow Jones industrial stocks measured against the S&P 500.