Beta Is A Useful Risk Metric—If You Use It Correctly

In a world awash in identified risk factors, the original quantitative profile of investment risk long ago fell from grace. If you spend ten minutes on the internet searching for research that finds beta to be irrelevant, at best, you’ll quickly line up reading material for a month. But the majority of the criticism focuses on beta’s weakness for parsing individual stocks. By that standard, beta suffers several well-known and reportedly fatal flaws as a risk measure. But applied to asset classes in the context of portfolio design and management, beta’s far from dead.

Beta, of course, is the risk metric in the capital asset pricing model (CAPM) and quantifies the relationship between an investment and the portfolio. A beta of 1.0 indicates that an investment’s risk profile matches the market portfolio’s risk. Higher (lower) betas equate with relatively higher (lower) risk.

As numerous studies over the years have shown, beta has minimal, if any, value for analyzing individual stocks. A key issue: low-beta shares tend to outperform high-beta shares. Not good if you’re expecting beta to proxy for risk. Therein lies the basis for the success of low-volatility equity portfolios, which violates CAPM’s logic.

Beta’s track record is wobbly at best for stock portfolios, but the risk metric looks better for multi-asset-class strategies. Perhaps that’s not surprising since CAPM is focused on the “market” portfolio, which in theory holds all assets. By that standard, trying to use beta and CAPM in an equity-only context is asking for trouble.

As a toy example, consider how beta and return compare for the major asset classes, based on a set of proxy ETFs:

The chart below plots these ETFs for beta vs. trailing 5-year annualized total return. The relationship isn’t perfect, but there’s a general connection between risk and return a la CAPM. Higher return tends to align with higher return.

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Disclosure: None.

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