By Leonard Sloane

Published: November 3, 1984

There is an old saw on Wall Street that you

can either eat well or sleep well — but not

both. The moral, of course, is that risk and the willingness to accept it are perhaps the key elements in determining the likelihood of stock market profits.

Beta, an analytical technique long used by securities analysts and portfolio managers, is one of the best-known ways of measuring that risk. With an increasing number of stockbrokers and mutual fund managers also using beta, many small investors are now becoming more aware of its use and, in particular, its value in the securities selection process.

Beta is a measure of the systematic risk of an asset — such as shares of a mutual fund or an individual’s stock portfolio — illustrating how volatile it is relative to the market as a whole. If the asset has a beta lower than 1, it is considered to be »defensive.» If it has a beta higher than 1, it is considered to be »aggressive.» And if the asset has a beta of 1, it is neither.

»You can look at any individual stock or portfolio and see how it performs relative to the market,» said James B. Cloonan, chairman of the American Association of Individual Investors, an independent organization with headquarters in Chicago. »There is a direct correlation between risk and reward in the stock market, so the higher the risk, the higher the reward.»

Beta, an outgrowth of modern portfolio theory, is a regression analysis technique that quantifies the volatility of particular securities in relation to the stock market, with the Standard & Poor’s 500-stock index normally representing the total market. A beta of 2 means that these securities move twice as much — both on the up side and the down side — as the market in general. In contrast, a beta of 0.5 means that the securities move half as fast as the market in general. Fractional differences between two betas, such as 0.1 and 0.2, are usually not believed to be significant in any comparison, though.

As a measurement of the sensitivity of the price of a fund or a portfolio to overall fluctuations in the prices of other stocks, beta differs from alpha, another Greek letter principle. Alpha refers to expected fluctuations in the price of a stock resulting from characteristics unique to that stock, instead of from general market conditions. When securities are selling below the prices suggested by their calculated alpha and beta, professionals in the business frequently consider them to be a good buy.

Even though it is a relative valuation, however, beta should be weighed further against the annual return from an investment in order to arrive at a risk-adjusted rate of return. The reason is that investors thereby can correlate their potential for gain with the degree of volatility that they are agreeing to assume.

»You certainly should pay attention to what kind of return you’ve gotten compared with the volatility you’re exposed to,» said William D. Corneliuson, president of the management company for the Milwaukee-based Strong mutual funds. »If the rate of return is mediocre, you have to ask yourself, ‘Am I flirting with fire?’ »

Not all academics accept beta as gospel and, along with other stock market theories, there are problems in attempting to apply it to all situations. One of the most troublesome problems is that some stocks or funds do not move at the same rate in both rising and falling markets. Thus the beta might vary significantly depending on which period of time is chosen for the tabulation.

Another difficulty is that the beta concept, which was created to serve institutional investors, is oriented toward measuring short-term risk. But individual investors are often more concerned with longer holding periods rather than with in-an-out buying and selling. Beta, therefore, may not be a process that is as suitable for their needs as it is for those who trade in large blocks of stock.

In addition, many securities traded on the American Stock Exchange and the over-the-counter market are not comparable to the securities on the S.&P. 500 list. So unless a broader indicator is used as a proxy for the overall stock market, the calculation could be meaningless to these holders.

The computation of beta requires either statistical plotting or computer skills that may be beyond the ability of most stockholders. Nevertheless, you might be able to obtain this information from other sources.

Mutual fund holders can request the figure from their fund or by consulting such books as »The Individual Investor’s Guide to No-Load Mutual Funds,» published annually by the individual investors association. As for a stock portfolio, a request to the broker handling your account could result in the beta data.

Beta is just one of the methods that investors can follow in picking and retaining stocks and funds. Nevertheless, because it is considered such a meaningful indicator of risk, it offers individuals a means of buying securities in keeping with their own attitudes toward risk acceptance and risk aversion.