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Monday, May 4, 2009

Extreme and interesting cases

  • Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.
  • Beta can be zero. Some zero-beta securities are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does NOT mean that it is risk free. A beta can be zero simply because the correlation between that item and the market is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk free endeavor.
  • A negative beta simply means that the stock is inversely correlated with the market. Many precious metals and precious-metal-related stocks are beta-negative as their value tends to increase when the general market is down and vice versa.
  • A negative beta might occur even when both the benchmark index and the stock under consideration have positive returns. It is possible that lower positive returns of the index coincide with higher positive returns of the stock, or vice versa. The slope of the regression line, i.e. the beta, in such a case will be negative.
  • Using beta as a measure of relative risk has its own limitations. Most analysis consider only the magnitude of beta. Beta is a statistical variable and should be considered with its statistical significance (R square value of the regression line). Higher R square value implies higher correlation and a stronger relationship between returns of the asset and benchmark index.
  • Since beta is a result of regression of one stock against the market where it is quoted, betas from different countries are not comparable.
  • Staples stocks are thought to be less affected by cycles and usually have lower beta. Procter & Gamble is a classic example, who makes soap. Other similar ones are Philip Morris (tobacco) and Anheuser-Busch (alcohol). Utility stocks are thought to be less cyclical and have lower beta as well, for similar reasons.
  • Foreign stocks may provide some diversification. World benchmarks such as S&P Global 100 have slightly lower betas than comparable US-only benchmarks such as S&P 100. However, this effect is not as good as it used to be; the various markets are now fairly correlated, especially the US and Western Europe.

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