Investment Statistics 301
Chart of the Week for July 21-27, 2000
Many investors are familiar with the statistic beta, which measures the volatility of an investment relative to the market. Beta is usually expressed relative to the S&P 500 Index. A fund with a beta lower than 1 is thought to have less risk than the S&P 500, while a beta greater than one indicates greater-than-market risk.
However, beta needs a statistical partner to be truly useful. That partner is a statistic called R2, and it measures the percentage of variability explained by beta, or market risk. The higher the R2, the greater the reliability and explanatory power of beta. A low R2 means that the fund’s return is affected by factors that don’t have as strong an impact on the general market.
The chart above illustrates how fund performance can differ from that suggested by beta. Fund X has a beta of 0.96, indicating just slightly less risk than the S&P 500. But as the return pattern shows, Fund X has much higher volatility than expected, given its beta. In fact, the variability of Fund X’s return is nearly 50% higher than that of the market. Not surprisingly, R2 is low, explaining just 70% of Fund X’s return relative to the market.
The moral of the story? Don’t rely on beta alone to express the potential variability of an investment. If you do, you may be in for a wilder ride than you expected.
This illustration was compiled by information from outside sources. These companies are not affiliated with ICMA-RC. This information is being provided for educational purposes and is not intended to be construed as or relied upon as investment advice. ICMA-RC does not offer specific tax or legal advice. Individuals are advised to consider any new investment strategies carefully prior to implementing. Investment information can change rapidly and the changes can be significant particularly in volatile markets. For this reason “as of”’ dates are provided for specific data where applicable. The information should not be considered current after the dates provided.
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