With this article I am starting a new series of blogs concerning investment terminology. Today’s topic is beta. According to Investopedia, beta is “a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.” In other words, it is a measure of risk as related to the market. Beta is also used in the capital asset pricing model to help determine the expected return of a security or portfolio.
To quantify the use of beta, it is assumed that the market has a beta of 1.00 and a security or portfolio generally has a beta of something other than 1.00 (unless we are looking at an index fund which should then have an equal beta of 1.00). If we consider the S&P 500 Index as the market, the beta would be 1.00 and stocks or portfolios being compared to the S&P 500 Index would have a beta either above or below 1.00. Should a stock have a beta of 1.10 it would be considered as being 10% more volatile than the S&P 500 Index, while a stock with a beta of 0.90 would theoretically be 10% less volatile than the Index (or market). Generally speaking, a security or portfolio with a beta above 1.00 would be considered a high beta stock and a security or portfolio with a beta below 1.00 would be considered a low beta stock.
Since the measure is in response to the swings in the market, one can make a judgment as to how a security or portfolio will behave in response to that market swing. For example, if the market moved higher by 5%, a stock with a beta of 1.10 should move up by 5.5%. On the other hand, should the market decline by 5%, a stock with a beta of 1.10 should fall by 5.5%. A stock with a beta of 0.90 would see an upward move of 4.5% and a decline of 4.5% under similar market conditions. Therefore, stocks with beta’s above 1.00 tend to be riskier but also have the potential for higher returns and stocks with beta’s below 1.00 tend to be less risky but also have the potential for lower returns. Investors need to be careful in how they apply this measure across indexes or markets. In other words, it would not be a good idea to compare the beta of a commodity investment with that of a stock in the S&P 500. Similarly, small cap stocks should be measured against a small cap index and not directly against the S&P 500.
When making investment decisions, an investor should consider their risk tolerance and then choose individual securities or design a portfolio based, at least in part, on their risk tolerance level. Beta can be a useful measure in making those decisions. In fact, a portfolio can be put together with a variety of beta’s and still come out with a lower portfolio beta than many of the individual betas due to the benefits of diversification. In other words, by diversifying a portfolio one could end up with a less risky portfolio that could offer greater returns. We will consider this in the next article in this series when we discuss systematic and unsystematic risk. Future articles will discuss the use of alpha, standard deviation, style investing, and so on.