Under a multi-factor model, each security has not just one Beta, but rather a set of Betas, each quantifying the stock's sensitivity to a particular large-scale influence on stock prices. These influences are termed "macroeconomic risk factors," or just "risk factors." Each stock has a set of Betas--one for each risk factor. Each Beta gives the risk exposure to the corresponding "risk factor."
A great deal of research has been performed to determine the best way to implement a multi-factor approach. In theory there could be hundreds or even thousands of factors, but it's difficult to see how an investor could make practical use of such a mass of data, or how the multitude of values could be computed with any confidence in statistical reliability. Moreover, if an investor were to constrain too many variables at once, their ability to make use of other information (such as fundamental analysis) would be diminished. Thus, the consensus has been that it is desirable to keep the number of Betas relatively small.
For risk management purposes, a useful approach is to select major economic factors that can clearly be shown to affect stock returns, and that do so in a significant way over a long period of time. The primary sources of economy-wide surprise, according to leading financial analysts are:
Confidence Risk exposure reflects a stock's sensitivity to unexpected changes in investor confidence. Investors always demand a higher return for making relatively riskier investments. When their confidence is high, they are willing to accept a smaller reward than when their confidence is low. Most assets have a positive exposure to Confidence Risk. An unexpected increase in investor confidence will put more investors in the market for these stocks, increasing their price and producing a positive return for those who already held them. Similarly, a drop in investor confidence leads to a drop in the value of these investments. Some stocks have a negative exposure to the Confidence Risk factor, however, suggesting that investors tend to treat them as a "safe haven" when their confidence is shaken.
Time Horizon Risk exposure reflects a stock's sensitivity to unexpected changes in investors' willingness to invest for the long term. An increase in time horizon tends to benefit growth stocks, while a decrease tends to benefit income stocks. Exposures can be positive or negative, but growth stocks as a rule have a higher (more positive) exposure than income stocks.
Inflation Risk exposure reflects a stock's sensitivity to unexpected changes in the inflation rate. Unexpected increases in the inflation rate put a downward pressure on stock prices, so most stocks have a negative exposure to Inflation Risk. Consumer demand for luxuries declines when real income is eroded by inflation. Thus, retailers, eating places, hotels, resorts, and other "luxuries" are harmed by inflation, and their stocks therefore tend to be more sensitive to inflation surprises and, as a result, have a more negative exposure to Inflation Risk. Conversely, providers of necessary goods and services (agricultural products, tire and rubber goods, etc.) are relatively less harmed by inflation surprises, and their stocks have a smaller (less negative) exposure. A few stocks attract investors in times of inflation surprise and have a positive Inflation Risk exposure.
Business Cycle Risk exposure reflects a stock's sensitivity to unexpected changes in the growth rate of business activity. Stocks of companies such as retail stores that do well in times of economic growth have a higher exposure to Business Cycle Risk than those that are less affected by the business cycle, such as utilities or government contractors. Stocks can have a negative exposure to this factor if investors tend to shift their funds toward those stocks when news about the growth rate for the economy is not good.
The danger to an investor is that exposure to economy-wide surprises will be taken inadvertently. If an investor focuses on selecting stocks with superior performance, then using an appropriate portfolio analysis will insulate the investor's return from unwanted economy-wide surprises. In addition, superior stock selection can be combined with active pursuit of certain types of risks. For example, a speculative investor anticipating an upturn in economic activity may decide to accept a greater degree of Business Cycle Risk, taking a conscious, increased risk exposure in order to achieve a higher return.
But whether or not an investor decides to undertake speculation, it is always
desirable to substitute concrete knowledge for guesswork. Risk and return
analysis removes the guesswork by measuring the exposure to various types of
risk, both for individual stocks and portfolios. And, using portfolio analysis, an
investor can control these exposures over time as part of a strategic investment
plan.
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