What is Beta?

Beta ($\beta$) is a measure of the volatility, or systematic risk, of a security or portfolio relative to the market as a whole (usually the S&P 500). Stocks with a beta greater than 1.0 can be interpreted as more volatile than the S&P 500.

Beta is used in the capital pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method to price risky securities and to generate estimates of expected returns on assets, considering both the risk of those assets and the cost of capital.

How beta works

The beta coefficient can measure the volatility of an individual security relative to the systematic risk of the entire market. In statistical terms, beta represents the slope of the straight line through a regression of data points. In finance, each of these points represents the returns of an individual security relative to those of the market as a whole.

Beta effectively describes the activity of a security’s returns in response to market fluctuations. The beta of a security is calculated by dividing the product of the covariance of the security’s returns and market returns by the variance of market returns over a given period.

The beta calculation is as follows: $\beta=\frac{Covariance(R_e,R_m)}{Variance(R_m)}$

where: $R_e$ is the return on a single security, $R_m$ is the return of the overall market, Covariance = how the changes in a stock’s returns are, relative to changes in market returns, Variance = how far market data points deviate from their mean value

Beta calculation is used to help investors understand whether a stock is moving in the same direction as the rest of the market. It also gives an indication of the volatility or riskiness of a security relative to the rest of the market. For beta to provide useful indications, the market used as a benchmark must be correlated to the security. For example, calculating the beta of a bond ETF using the S&P 500 as a benchmark would not provide much useful guidance to an investor because bonds and stocks are too different.

Understanding beta

Ultimately, the investor uses beta to try to assess the risk that a security adds to his or her portfolio. While a security that deviates little from the market does not add much risk to the portfolio, it does not increase the return potential.

To ensure that a specific security is compared to the right benchmark, it should have a high R-squared to the benchmark. R-squared is a statistical measure that indicates the percentage of a security’s historical price movements that can be explained by movements in the benchmark index. When using beta to determine the degree of systematic risk, a security with a high R-squared value, relative to its benchmark, might indicate a more relevant benchmark.

For example, an exchange-traded fund (ETF) on gold, such as the SPDR Gold Shares (GLD), is linked to the performance of gold bullion.

Consequently, a gold ETF would have a low beta and an R-square relationship with the S&P 500.

One way for an equity investor to think about risk is to divide it into two categories. The first category is the so-called systematic risk, i.e. the risk of a fall in the entire market. The 2008 financial crisis is an example of systematic risk; no amount of diversification could have prevented investors from losing value in their equity portfolios. Systematic risk is also known as non-diversifiable risk.

Unsystematic risk, also known as diversifiable risk, is the uncertainty associated with a single security or sector. For example, the surprise announcement that Lumber Liquidators (LL) sold hardwood flooring with hazardous levels of formaldehyde in 2015 is an example of unsystematic risk.

It is a risk specific to that company. Unsystematic risk can be partially mitigated through diversification.

Types of beta values

Beta value of 1.0

If a security has a beta of 1.0, it indicates that its price activity is highly correlated to the market. A security with a beta of 1.0 presents a systematic risk. However, the beta calculation cannot detect any unsystematic risk. Adding a security to a portfolio with a beta of 1.0 does not add any risk to the portfolio, but neither does it increase the probability that the portfolio offers an excess return.

Beta value less than one

A beta value of less than 1.0 means that the security is theoretically less volatile than the market. The inclusion of this security in a portfolio makes it less risky than the same portfolio without the security. For example, utility stocks often have a low beta because they tend to move more slowly than market averages.

Beta value greater than one

A beta greater than 1.0 indicates that the price of the security is theoretically more volatile than the market. For example, if the beta of a security is 1.2, it is assumed to be 20% more volatile than the market. Technology and small-cap stocks tend to have higher betas than the market benchmark. This indicates that adding this stock to a portfolio will increase the portfolio’s risk, but may also increase its expected return.

Negative beta value

Some securities have a negative beta. A beta of -1.0 means that the security is inversely correlated to the market benchmark on a 1:1 basis. This security can be regarded as a benchmark stock. This security can be regarded as an opposite and mirror image of the performance of the benchmark. Put options and inverse ETFs are designed to have negative betas. There are also some industry groups, such as gold miners, where a negative beta is common.

Beta in theory and beta in practice

Beta theory assumes that equity returns are normally distributed from a statistical point of view. However, financial markets are prone to big surprises. In reality, returns are not always normally distributed. Therefore, what the beta of a stock might predict about its future movement is not always true.

A security with a very low beta might have smaller price fluctuations, but might still be in a long-term downward trend. Therefore, adding a downtrending stock with a low beta only reduces risk in a portfolio if the investor defines risk strictly in terms of volatility (rather than as loss potential). From a practical point of view, a low-beta stock going through a downtrend is not likely to improve the performance of a portfolio.

Likewise, a high-beta stock that is volatile in a predominantly bullish direction will increase a portfolio’s risk, but may also add gains. It is recommended that investors who use beta to evaluate a security also evaluate it from other perspectives, such as fundamental or technical factors, before assuming that it adds or removes risk from a portfolio.

Disadvantages of beta

Although beta can offer useful information for evaluating a security, it has certain limitations. Beta is useful for determining the short-term risk of a security and for analysing volatility to arrive at equity costs when using the CAPM. However, since beta is calculated on the basis of historical data, it becomes less meaningful for investors trying to predict the future movements of a security. Beta is also less useful for long-term investments, as the volatility of a stock can change significantly from one year to the next, depending on the growth phase of the company and other factors. Furthermore, the beta measure of a particular stock tends to fluctuate over time, making it unreliable as a stable measure.

What is a good beta for a security?

Beta is used as an indicator of the riskiness or volatility of a security relative to the broader market. A good beta therefore depends on your risk tolerance and objectives. If you want to replicate the broad market in your portfolio, for instance through an index ETF, a beta of 1.0 would be ideal. If, on the other hand, you are a conservative investor who wants to preserve capital, a lower beta might be more appropriate. In a bullish market, betas above 1.0 will tend to produce above-average returns, but also higher losses in a bearish market.

Is beta a good measure of risk?

Many experts agree that Beta, while providing some information about risk, is not an effective measure of risk per se. Beta merely looks at the past performance of a stock relative to the S&P 500 and provides no indication for the future. Furthermore, it does not take into consideration a company’s fundamentals or its growth and earnings potential.

How is the Beta of a stock interpreted?

A Beta of 1.0 for a stock means that its volatility was equal to that of the broader market (i.e. the S&P 500 index). If the index goes up or down by 1%, the stock also moves on average. Betas above 1.0 indicate higher volatility: if the beta were 1.5 and the index moved up or down 1%, the stock would move 1.5% on average. Betas below 1.0 indicate lower volatility: if the stock had a beta of 0.5, it would only go up or down half a percentage point when the index moved 1%.

KEY RESULTS

Beta ($\beta$), primarily used in the Capital Asset Pricing Model (CAPM), is a measure of the volatility - or systematic risk - of a security or portfolio relative to the market as a whole. Data on the beta of an individual security can only provide the investor with an approximation of how much risk the security will add to a (presumably) diversified portfolio. For the beta to be meaningful, the security must be correlated to the benchmark used in the calculation. The S&P 500 has a beta of 1.0. Stocks with a beta above 1 will tend to move with more momentum than the S&P 500; stocks with a beta below 1 with less momentum.

Source: www.investopedia.com