Americans like factoids. Because we are buried with tons of information, we love it when someone sorts the noise into simple to understand lists. Thus, “Good Morning America” tells us Michigan’s Sleeping Bear Dunes is the most beautiful place in the U.S.; we know from the Princeton Review that the University of West Virginia is the top party school in the country; and we know Gwyneth Paltrow is at the top of People Magazine’s list of the most beautiful people.
Unfortunately, for most of us, these lists are just entertainment. They aren’t useful, are based on opinions and only add to our daily dose of factoids.
Some lists, however, are not based on opinions and are not merely entertainment, but can be quite useful. For example, Consumer Reports magazine develops lists of products and services sorted from best to worst based on in-depth research and testing.
Finance professors like that approach. We like numbers. Our careers depend on using complex statistical techniques to sort meaning out of the noise of hundreds, thousands, or even millions of data values.
Consider for example, the problem of trying to measure the risk of investing in a particular stock. We start by defining risk. Obviously, investors don’t see the humor in watching their stock holdings tank during a recession. That’s a risk of owning stocks: Prices are dragged down when the stock market tanks.
Accordingly, finance professors define risk as the degree a company’s stock price moves up and down relative to what the entire stock market is doing. A stock whose price rises or falls twice as much as the stock market is twice as risky as average.
We call that measure of risk the stock’s beta: The higher the beta, the riskier the stock. A beta of 2 implies the stock’s return will be twice the market’s return. For example, if the S&P 500 stock index rises 15 percent, the stock’s return will rise twice that, or 30 percent. If the market falls 20 percent, the stock’s return will fall 40 percent.
These relationships aren’t magic and aren’t opinions. They are based on how stock returns have moved relative to the S&P Index over the past five years.
The table below ranks West Michigan publicly traded stocks based on their beta values.
Relative riskiness of West Michigan stocks
Macatawa Bank 2.0
Herman Miller 1.7
Independent Bank 1.5
Universal Forest Products 1.2
Wolverine Worldwide 1.0
Mercantile Bank 0.8
Choice One Financial -0.2
Community Shores Bank -1.9
Note the following points:
The higher the beta, the more the stock’s price is whipped around by stock market changes. A stock with a beta greater than 1.0 is riskier than average.
The average stock has a beta value of 1.0. Its risk is average.
A beta value less than 1.0 is safer than average: Stock price won’t vary as much as the market. An investor who wants to hold stocks whose prices don’t vary as much as the market would hold these low beta stocks.
A negative beta stock seems like a gift from the heavens. When the market falls, the stock price rises. For example, Muskegon-based Community Shores Bank’s stock price will rise 38 percent when the market falls 20 percent. The beta values of negative beta stocks cannot be trusted, however. They almost always are an artifact of some unique and temporary situation over the past five years and will surely change to a positive value in the future.
Beta values change over time, but usually not drastically. On average, they are reliable predictors for the next one to two years. The greatest exception to this general statement? Negative beta stocks.
You can find stock beta values on the Internet by searching for “key statistics” for your stock.
An individual stock’s beta value is neither good nor bad. Rather, it’s a piece of information useful to investors. Investors in Macatawa Bank and Steelcase know their stock prices are especially risky relative to the market, while Perrigo investors know changes in the company’s stock price don’t have much to do with changes in the overall stock market.
In addition, some investors have a higher tolerance for price volatility than others. Of equal importance, risk is only part of our decision to buy or sell stocks. Return is just as important. A high-risk stock is a great investment if its return more than compensates for the risk.
If you own individual West Michigan publicly traded stocks, you can use knowledge of beta values to understand the degree of volatility you are likely to experience and adjust your holdings accordingly. For investors, that’s more useful information than knowing Gwyneth Paltrow tops the list of most beautiful people.
Dr. Gregg Dimkoff and Dr. Eric Hoogstra are faculty members in the finance department of Seidman College of Business, Grand Valley State University.