Beta Measures Risk! But, Is It So?

beta-volatility
Does beta measure risk?

What is Beta?

Beta measures volatility of a stock (or portfolio), with the rest of the market (benchmark index).

Symbol of Beta

β

Benjamin Graham
Beta is a more or less useful measure of past price fluctuations of common stocks.

What bothers me is that authorities now equate the beta idea with the concepts of risk.

Price variability, yes; risk, no.

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Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.

Warren Buffett on Beta
Employing databases and statistical skills, these academics compute with precision the beta of a stock – its relative volatility in the past and then build arcane investment and capital allocation theories around this calculation.

Warren Buffett
The Washington Post Company in 1973 was selling for $80 million in the market.

At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.

The company owned the Post, Newsweek, plus several television stations in major markets.

Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

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Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.

And to people that think beta measures risk, the cheaper price would have made it look riskier.

This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Warren Buffett
Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility.

Stock price is not that important to me, it just gives you the opportunity to buy at a great price.

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Warren Buffett
The riskiness of an investment is not measured by beta but rather by the probability – the reasoned probability of that investment causing its owner a loss of purchasing-power over his contemplated holding period.

Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Warren Buffett
If someone starts talking to you about beta, zip up your pocketbook.

Moral of the Story
Beta does not measure risk.