Beta: A Proven Tool to Estimate Risk
One of the most frequent qualifiers I offer when discussing investments with people is “depending on your risk tolerance.” That’s sound and easy advice to dispense, but for many people it may be nebulous. Today I want to put more definition around that advice.
The beta of a stock is a measure of that stock’s daily movements compared to a broader market index, typically the S&P 500. A stock with a beta of less than 1.0 means that its daily moves are on average less than the market index. A stock with a beta higher than 1.0 historically moves more than the market index. A stock with a negative beta moves in the opposite direction from the market index.
Let’s consider companies in each category. For conservative investors, utilities are one of the safest equity investments available. They are considered low volatility investments.
NextEra (NYSE: NEE) is among the largest electric utilities in the U.S. According to the S&P Global Market Intelligence database, NextEra has a five-year beta of 0.26. That means that over the past five years, NextEra has only been 26% as volatile on a daily basis as the S&P 500.
This measure of course works in both directions. The low beta suggests that NextEra won’t rise as much as the S&P 500 on up days, and won’t decline as much on down days. However, that doesn’t mean that over a long time frame NextEra only delivers 26% of the S&P 500’s returns. To the contrary, NextEra has actually outperformed the S&P 500 over the past five years, with a return of 96% versus the S&P 500’s 47% return.
But a low beta means that NextEra’s downside moves are on average less than the S&P 500’s. As a recent case in point, last year between December 3 and December 24, the S&P 500 declined by 15.7%. NextEra, on the other hand, declined by 7.9% over that period.
Now consider a more volatile stock. Streaming video giant Netflix (NSDQ: NFLX) has a five-year beta of 1.39. That means its daily moves have been 39% more volatile than the S&P 500. This is a situation in which a person needs a higher risk tolerance, because Netflix can move quickly with respect to the market.
Over the past five years, Netflix has returned 460%, nearly 10 times the performance of the S&P 500. But between mid-June and mid-December of last year, Netflix shares fell by 44%. During the same time period, the S&P 500 declined by only 11%. Had you bought Netflix at the top last July, it may take a long time to recover your money, presuming you didn’t sell your shares in a panic.
My colleague Jim Fink, chief investment strategist of Options for Income and Velocity Trader, also notes that high beta stocks are often overvalued, writing:
“Investors are greedy and bid up the price of high-beta stocks above their fair value, so high-beta stocks suffer downside volatility from BOTH their high betas and reversion to fair value.”
This is the main takeaway from beta: It gives some relative measure of how quickly shares can drop in a down market. If you have a low risk tolerance, for example if you are retiree counting on income from your shares, then stick with low beta stocks.
The Case of PG&E
Let’s look at one final case to highlight how beta can be misleading.
PG&E Corporation (NYSE: PCG) has a five-year beta of -0.45. That would imply that its daily moves on average are in the opposite direction of the S&P 500’s moves. But if you look at its performance over the past five years, up until October 2017, PCG’s five-year performance was ahead of the S&P 500. A calculation of the five-year beta at that point would have looked similar to that of NextEra’s. It would have been low, but positive.
What happened was a series of sharp drops in the share price, beginning in October 2017, at a time when the S&P 500 was rising. These drops were a result of a series of unfortunate events for PCG, including a dividend cut, massive liability from the Camp Fire in California, and the subsequent declaration of bankruptcy. The resulting drops caused the beta to turn negative, which might imply to some investors that PCG generally falls when the S&P 500 is rising.
Knowing the beta in October 2017 would have implied that PCG was a safe stock, but that didn’t prevent the company from imploding. That’s because beta is a backward-looking measure, and can’t anticipate future events that can cause a company to crash to the ground.
Beta is like many other measures. It is a tool that informs us of relative historical volatility, but past performance isn’t always a perfect indicator of future performance. However, generally speaking, a basket of low beta stocks is preferable for conservative investors over a basket of high beta stocks.
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