Saturday, February 7, 2009

What betas can... and cannot do...

There is no concept that is more abused, and more misinterpreted, than beta in corporate finance. I have heard betas blamed for everything from global warming to the market collapse. "Warren Buffet does not use beta", the refrain goes, "so why should I?"

I think the biggest mistake that people make is to wrap betas up with the assumptions of the capital asset pricing model (CAPM). Does the CAPM make unrealistic assumptions about no transactions costs and no private information to get to its final conclusion (that all exposure to market risk can be captured in a beta, which should then be the sole determinant of the differences in expected returns)? Absolutely. However, just because you don't like the CAPM's rigidity does not mean that you throw the baby out with the bathwater and abandon beta as a measure of risk, or worse, use no measure of risk at all.

I think of betas as measures of relative risk, with the risk defined as exposure to macro economic variables (interest rates, overall economic growth, inflation). Thus, a stock with a beta of 1.2 is 1.2 times more exposed to macro economic risk than the average stock in the market. That proposition stands, whether one buys into the CAPM or not. Seen from that perspective, here are the things betas cannot do:
1. Explain changes in returns for the entire market. The betas for all stocks cannot go up at the same time, since they have to average out to one. (This is in response to those who have argued that the recent drop in equity prices can be explained by an increase in betas across the board.)
2. Capture emerging market risk. If we regress the returns on emerging market stock against emerging market indices, which is the standard practice for most estimation services, the average beta for Indonesian stocks will be one, as will the average beta of Swiss stocks. If we run regressions against a global index, the results are often unpredictable, with betas for emerging market companies often dropping simply because they are such as a small part of the index.
3. Capture firm specific risk: Betas cannot incorporate risks that affect only a firm or a few firms, even if these risks are huge. Thus, a tobacco company's beta cannot reflect litigation risk and a biotech firm's beta will not capture the uncertainty inherent in the FDA approval process.

Here is what betas can do. They can capture shifts in risk across the market. If a sector gets riskier, its beta should go up, but there has be another sector whose risk has to go down to compensate. Thus, banks will have higher betas today than they did a year ago but technology firms may have seen their betas decline, as they have held up fairly well in this downturn. They provide simple, intuitive and surprisingly effective snapshots of how risky an investment is, relative to the rest of the market, especially if you are an investor with multiple investments in your portfolio.

I do have to mention in closing that running a regression of stock returns against a market index is both a terrible way of estimating betas and of thinking about betas. However, this post is already way too long for me to suggest alternatives to regression betas. That will come in the next post.

12 comments:

Dhananjayan said...

I agree with Professor's view. If beta is not the correct measure of risk, what else can be taken as risk measuring tool? If Mr. Buffet is not using beta, it is because he is gonna hold a stock for his life time. Only Mr. Buffet can do that. Not all.

aymru said...

There is a huge difference between investment and Trading. Investment is what Warren Buffet does(he holds a huge ownership stock in the particular company.) He analyses a company's future prospects by understanding the business, Market for the products produced by that company. Which is very much difficult for a person who is engaged in the activities like buying a stock for a certain period,or buying a call option, trading in Futures(allowed in India) etc.

Aswath sir, How an individual can analyze a stock for trading practice?

Aswath Damodaran said...

The contrast between investing and trading does not really make sense. If you invested in Google long term, do you not think that you are going to be exposed to more risk than investing in Coca Cola? An investment is risky and having a long time horizon cannot make real risk go away. As for Buffet, I would not take everything he says at face value. He may not adjust his expected returns for risk but he sure does adjust the cash flows.

STF said...

I'm actually in the middle of teaching Ch. 4 of "applied corp finance" right now in my course right now, so this is timely.

Just found this blog so haven't posted here before, but many thanks for all the help you provide on your website! I'm an economist who was converted to teaching finance about 8 years ago and ended up loving it . . . but there's been a steep learning curve to become any good at it. Your books and website have been tremendous help to me.

By the way, and a bit off topic, I just received my copy of strategic risk taking. Are you planning a course around this material in the future? If not, I'd be interested in hearing how you might be using it or suggest using it in the classroom.

Thanks.

Mahesh Sethuraman said...

Hi,

This brings me to another question that was very often asked in placement interviews in B-Schools by some of the equity research companies. Can there be companies with negative beta? And if yes then is CAPM an invalid framework?

I have never quite got a convincing answer for this from most people. I know there are companies with negative beta in the market. But isn't that because of our narrow understanding of index being a true representation of the market. If you have to take the market as a whole - there should n't be a negative beta right?

And given this limitation, how do we adjust for the same in calculating the Cost of Equity within the CAPM framework?

Aswath Damodaran said...

I will address the negative beta question in another post, but the true beta for an asset can be negative, if acts as insurance against a major macro economic risk. One example that is often give is gold, a hedge against inflation... If the bulk of your portfolio is composed of financial assets that can be hurt by unexpectedly high inflation, adding god to this portfolio can reduce its overall risk.

Roshan Chutkey said...

Dear Sir,
Apart from risk-free rate issues, this is also a scenario where assets will likely be impaired. Once impairment sets in, return ratios, like, ROE, ROA will be inflated (of course, returns themselves are negative! Still, these ratios are inflated owing to denominators!)

Doesn't this call for adjusting these ratios? How should one do the adjustment in a scenario like this? Request your comments.

Regards
Roshan

Mahesh Sethuraman said...

Could you also give us your take on Fama-French's critical review of CAPM in one of the posts please?

eran said...

I second Mahesh Sethuraman's comment, if it's not too much trouble

eran said...

When you say all betas must average 1, is it theoretically speaking?

Aswath Damodaran said...

The betas have to average to one, on a weighted average basis, because they are all computed against a common index.

eran said...

Of course, but in practice, if I compute a weighted average beta for the entire market against the S&P 500 (for example), can I get a result higher than 1? After all, not *all* stocks are included in that index so my weights aren't any good. Is there a known index that will yield an average beta of 1 for the entire market?