Beta and MDD

Today, we can easily buy and sell stocks using our smartphones. But before buying a stock, there is something important to consider: risk. Stock prices can rise, but they can also fall. Sometimes, investors lose much more money than they expected. So how can we measure the risk of investing in a stock? Two measurements can help us understand this risk. They are beta and Maximum Drawdown, or MDD. Both are used to examine investment risk, but they measure different things. First, beta measures how sensitive a stock is to movements in the overall stock market. The movement of the overall market refers to changes in the prices of many stocks taken together. In the United States, investors often use a stock market index such as the S&P 500 to understand how the market is performing. Suppose a stock has a beta of 1. This means that, historically, the stock has tended to respond to market movements by roughly the same percentage. When the market rises by 10%, the stock might tend to rise by about 10%. When the market falls by 10%, the stock might tend to fall by about 10%. But what happens when beta is higher or lower than 1? A stock with a beta of 1.5 tends to be more sensitive to market movements. If the market rises by 10%, the stock might rise by approximately 15%. If the market falls by 10%, the stock might fall by approximately 15%. On the other hand, a stock with a beta of 0.5 tends to move by about 5% when the market moves by 10%. Of course, these numbers do not predict exactly how a stock will perform. Beta is calculated statistically using historical returns to measure the relationship between a stock and the market. Therefore, a beta of 1.5 does not mean that a stock will always rise by 15% whenever the market rises by 10%. Beta is useful for understanding how much a stock tends to be affected by changes in the overall market. For example, when the economy weakens or interest rates change significantly, many stocks may fall at the same time. Stocks with higher betas tend to react more strongly to these market movements. However, a low beta does not necessarily mean that a stock is safe. If a company experiences serious financial problems or an unexpected disaster, its stock price may fall sharply even when the overall market is stable. Beta does not capture every risk associated with an individual company. So how can we find out how much a stock has actually fallen in price? This is where MDD becomes useful. MDD stands for Maximum Drawdown. It measures the largest percentage decline in a stock's price from a previous peak to a subsequent low during a specific period. For example, suppose a stock rises from $100 to $120. Investors who own the stock might hope that its price will continue to rise. But what happens if the stock then falls to $90? In this case, the stock has fallen by $30, from $120 to $90. Compared with its peak price of $120, this represents a decline of 25%. If this was the largest peak-to-trough decline during the period being examined, the stock's MDD for that period would be 25%. There is an important detail to remember. MDD is not calculated using the price at which an investor first purchased a stock. Instead, it measures the decline from a peak to a later low within the period being studied. As a result, an investor's actual loss may be different from the stock's MDD. MDD matters because it helps investors think about how much of a decline they might have to endure. For example, suppose someone invests $1,000 in a stock and its price falls by 25%. The investment would then be worth $750. How much would the stock need to rise for the investment to return to $1,000? It might seem that a 25% increase would be enough, but that is not correct. To grow from $750 back to $1,000, the investment would need to increase by approximately 33.3%. This happens because the percentage lost and the percentage needed to recover are calculated from different starting amounts. The larger the loss, the greater the percentage gain needed to recover it. Does an MDD of 40% mean that a stock will definitely fall by 40% in the future? Not at all. MDD only shows the largest decline that actually occurred during a particular period in the past. It does not tell us how much the stock will fall in the future. Also, the MDD of the same stock can be different depending on whether we examine the past year or the past ten years. To better understand the difference between beta and MDD, imagine two stocks. Stock A has a beta of 1.5 and an MDD of 20%, while Stock B has a beta of 0.7 and an MDD of 40%. Assume that the MDD values were calculated over the same period. Stock A was relatively sensitive to market movements, but its largest peak-to-trough decline during the period was 20%. Stock B was less sensitive to market movements, yet it experienced a 40% decline from a previous peak. This is possible because a stock can suffer a large loss due to problems at its own company, even when it does not usually move strongly with the overall market. In other words, a stock with a high beta does not necessarily have a high MDD, and a stock with a low beta does not necessarily have a low MDD. These two measurements show investment risk from different perspectives. Beta can also change depending on which market index is used as a benchmark, while MDD can change depending on the period being examined. Therefore, when comparing two stocks, investors should consider not only the numbers themselves but also how those numbers were calculated. Of course, beta and MDD alone cannot tell us whether a stock is a good investment. Investors also need to consider what the company does, how much money it earns, how much debt it has, and whether its stock price is reasonable. Beta and MDD are tools for understanding risk, not numbers that guarantee future investment results. Ultimately, beta shows how sensitive a stock has historically been to movements in the overall market, while MDD shows how far its price has fallen from a previous peak in the past. Looking at both measurements can help investors understand the risks of a stock from more than one perspective. Successful investing is not just about thinking how much a stock's price might rise. It is also important to consider how much the price could fall and whether you could handle that decline. Beta and MDD are two of the many tools investors can use to think about these questions.