Risk Vs Reward

Source: Flickr user Daniel Lobo.

If you have read much investment literature, you have probably come across the statistic "beta," which is purported to be a measure of risk. Risk is a crucial thing for investors to assess, so it is important to understand that beta is a limited and imperfect way to measure it.

To more accurately take the measure of risk, it is important to recognize that risk is too multidimensional to be captured in one number.

Four problems with beta
Beta measures the periodic fluctuations of an investment and compares the magnitude of those fluctuations with a market standard. For stocks, that standard is often the S&P 500, so a mutual fund with a beta of 1.2 is assumed to vary up and down in price by 20% more than the S&P 500.

Beta is widely used because it is straightforward enough to calculate, but there are four problems with assuming that this approach actually measures risk:

  1. It measures the past, not the future. There are a variety of reasons why past performance is considered an unreliable indicator of future results. For an individual stock, a company's natural life cycle brings on changes in performance. The growth of a large, mature company is not likely to be as dynamic as that of a young up-and-comer. Also, success attracts competition, which can restrict continued growth. And sometimes the market for a given product may just dry up as technology and tastes evolve. The point is that as comforting as statistical precision might seem, measures like beta only tell you what you already know -- what has happened in the past. The future is a whole different chapter.
  2. It measures fluctuations, not loss. As vexing as the day-to-day or quarter-to-quarter fluctuations of an investment might be, when you step back and think about investing to fund a retirement that is 20 years in the future, you realize that measuring those fluctuations amounts to obsessing over trivia. Losses that are sustained throughout your investment time horizon are what really pose a risk to your long-term objective -- not a series of short-term oscillations.
  3. It ignores price. So a particular investment varies a lot in price -- is that good or bad? It really depends on whether you are buying low or buying high. If you get in at the market bottom, volatility can be a benefit, but near the market top, it can be disastrous.
  4. It is relative to an unreliable standard. If volatility is measured relative to the S&P 500, what does that mean to you? During a bear market, investments that are a fraction less volatile than a market index do not help you much. The S&P 500 does not care about your retirement goals, so you should not be overly concerned with the S&P 500.

Beta and other measures such as the Sharpe ratio that are based on short-term fluctuations capture a narrow characteristic of an investment's performance. The questions you have to ask yourself are how much that characteristic of short-term fluctuations matters to you, and whether you are more interested in the past than the future.

This article originally appeared on Money-Rates.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.