Correlated Variations On A Theme
If Beta Doesn't Work, What Does?
by William G.S. Brown, Ph.D.
Beta not doing it for you? Try the price regression line.
Conventional wisdom says that a stock (or stock fund) having a beta close to 1.0 will follow the market. Is that true? This piece of common knowledge can easily be verified by going to a stock or fund screen and searching for investments with beta greater than 0.99 but less than 1.01 and a five-year growth between -90% and +200%. In Figure 1 you will find the unusual values I came up with when I used the stock screener at www.hoovers.com.
FIGURE 1: STOCKS WITH THE SAME BETA. These results show clearly that beta is not a good indicator of how well a stock follows the market.
If a stock with a beta of 1.00 followed the market, then it would be impossible for one stock to gain 48.12% while another loses 50.64% when they both have a beta of 1.00. This clearly shows that beta is not a good indicator of how well a stock follows the market.
WHAT IS BETA, AND WHAT GOOD IS IT?
Beta is a good measure of volatility. It indicates how variations about the average gain behave. A beta of 1.00 suggests a stock's variations about the average gain are the same size and in the same direction as the index's variations. This is not the same as determining how well a stock price follows an index, however.
As an example, look at 12 monthly historical datapoints for the Standard & Poor's 500 (Figure 2) and the American Century Global gold Investors fund (Figure 3). The data is from February 1, 2001, through January 2, 2002.
Beta is based on period gains, which are computed for each month using the following formula:
...Continued in the October 2002 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.