Investment Basics

For as much value as Beta provides to investors who are limited by time and knowledge, there are some key drawbacks to using this statistical measure in your portfolio. Although the benefits clearly outweigh its flaws, being mindful of the limitations can help investors understand why and when they might expect to come into headwinds.

To start, one of the biggest disadvantages to Beta is that some equities are lumped into a category that might not fairly represent their business's activities. For example, a domestic equity that is part of the Dow Jones industrial might realize all of its revenues from emerging markets. However, if this security is measured against domestic markets and not emerging markets where there could be no correlation (neither positive nor negative correlation) in returns, what good is Beta at all? An investor will scratch her head when this security rises 15% in periods where the broader Dow Jones Industrial increases 20%, yet its published Beta figure is listed as 1.25. In other words, trusting that Beta is a 100% accurate risk measurement tool will not help, especially if the benchmark used is wrong from the start.

Another problem with Beta is that it is a measure of volatility. Regardless of how frequently Beta gets updated, it ignores the trend in overall volatility. This could result in frequent adjustment and ongoing to one's portfolio if one really want to stick to a specific portfolio Beta. For example, a Beta for a stock that just increases by 0.01 on a daily basis can quickly climb by 0.20 over the course of a full month. That small daily increase amounts to a huge increase in risk over the course of a month. The upward trend in volatility is therefore likely to be ignored and when it is something that the investor responds to, it could easily be way too late (the damage could have already been done or the trend could have reversed).

These are just a couple of easy to spot problems that can come up with your portfolio planning if all you rely on is Beta as a measure of risk. Ideally, investors who are trying to build their own portfolio should look at using other risk measurements to confirm or refute what they are finding when using Beta. This could include Standard Deviation as well as Correlation, both of which are considerably more intensive in terms of calculating but which can provide greater statistical reliability when working to mitigate risks within a portfolio.

--> Consider Income Mutual Funds as a way to mitigate risk in your portfolio. Visit MutualFundSite.org to find out more.

Chris has more than 18 years of financial services experience. He currently manages a website about video cards, like the GeForce GTX 470 at EVGAGeForce.com.