Wednesday, 17 November 2010

Et tu Beta? A downside risk betrayal

A central tenet of modern finance theory is that Beta is the appropriate measure of the systematic risk of stocks. The idea is that the higher the Beta, the more a stock price varies when the overall market rises or falls and thus the higher the risk.

Nothing is sacred or safe. Researchers Victor Bahhouth and Ramin Cooper Maysami in Risk Prediction Capabilities of P/E During Market Downturns, on AllBusiness' Academy of Accounting and Financial Studies Journal, tested how well Beta and P/E (the Price/Earnings ratio) predicted downside risk of all NYSE and NASDAQ stocks during the year of the latest big crash up to the end of October 31, 2008. Their conclusion: " ... beta's power was insignificant in predicting stock price movements ... On the other hand, the price-earnings ratio exhibited significant power in predicting stock price movements and accordingly was a more reliable measure of risk." An unkind cut it is indeed.

I wonder how many people actually have tried to use Beta to assess individual stock risk. I suspect most who look at individual stocks fall into the fundamental value assessment camp and so have been using P/E all along. When I looked at Waterfurnace recently, I came across some finance website or other that showed a Beta of 0.5 or so for the stock, presumably because WFI has been ultra-stable, trading around $25 for about the last four years. It made no sense to me to consider that figure of any use in judging its upside or downside risk.

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