Risks always go hand in hand with investing. Although returns are the selling point of investing and creating wealth, risks are like the monsters that hide under your bed, ready to grab your arm when you least expect it. Most beginners encounter the allure of high returns without fully understanding that it comes with commensurately higher risks. But what if there is a way to measure a security’s — or even a portfolio’s — risk at a signal glance? Well then, let me introduce beta. Beta is a measure of a stock’s volatility in the overall market. It helps quantifies the risk associated with an investment or portfolio. This lets investors see if security matches their risk appetite and potential returns easily.
Understanding beta
Beta is a statistical measure that compares the price movements of a security or investment portfolio to the movements of a benchmark or the broader market. For example, take any of those and put it up against the S&P 500. A beta of 1 implies that the security or portfolio moves in sync with the market. A beta greater than 1 suggests higher volatility, and a beta less than 1 indicates lower volatility than the market. In most literature, high-beta stocks are considered the riskiest but provide higher return potential, while low-beta stocks pose less risk but proportionally lower returns. In short, if a stocks beta value against the S&P 500 stock is:
1- the stock moves at the same pace as the S&P 500.
2 – for each point of movement that the market moves, the stock moves twice as much as the S&P 500.
0 – the stock does not have any correlation with the S&P500’s movements
-1- the stock moves the same way as the S&P 500 but in the opposite direction.
How to calculate beta
Beta can be calculated by the formula:
Covariance measures how two securities move together, wherein a positive covariance means that both securities move together in the same direction. A negative covariance means that the securities move opposite each other.
With variance, it refers to how far a stock moves relative to its mean. For example, variance is used in measuring an individual stock’s price volatility over time. Covariance is used to measure the correlation in price moves of two different stocks.
So the formula calculates beta using the covariance of the return of security with the return of the benchmark, divided by the variance of the benchmark’s return over a certain period. An alternative is to use beta could also be calculated by first dividing the security’s standard deviation of returns by the benchmark’s standard deviation of returns. The output is then multiplied by the correlation between the security’s returns and the benchmark’s returns.
This may sound complicated, but the good thing is that financial websites like Barchart, Nasdaq, etc., have a stock beta readily available.
What are the basic uses of beta?
Now that we know what beta is and how it is calculated, investors can use it in different ways to apply it to their investment strategy. For example:
Risk Assessment
Beta gives investors a glimpse at the level of systematic risk (the risk inherent to the entire market or market segment) associated with an investment. When the market moves, securities with higher beta values can experience more significant price swings, indicating higher risk and potential reward.
Risk-based performance evaluation
Beta can be used to evaluate an investment’s historical performance relative to the market. It allows investors to analyze whether a stock has outperformed or underperformed compared to its expected level of risk. For example, for stocks with a beta of 0.4-0.8, what is the typical return for these types of stocks, their average drawdown (how much investment is down from the peak before it recovers back to the peak), etc. Therefore allowing investors see which level of Beta would fit with their investment goals.
Portfolio diversification
Beta also allows investors to build well-diversified portfolios by selecting assets with different beta values. Depending on the state of the market, investors can easily find securities that don’t move alongside the market during downtimes and shift onto those that move with the market during bullish times. This allows investors to capitalize on the security’s characteristics and mitigates the risk of the portfolio when done properly.
Pros and cons of beta
Even though Beta does have many applications, it is still a fact that it has its advantages and shortcomings. Knowing them helps investors make realistic expectations and informed decisions. For example:
Advantages
Simplified Risk Assessment – Beta gives a straightforward measure of an investment’s relative risk, which makes decision-making easier in stock selection easier.
Market Comparison – Beta compares the movement between investments, allowing investors to gauge how correlated the performance of an asset is to the market.
Forecasting Potential – Beta helps investors anticipate how a stock’s price may move alongside market fluctuations due to its ability to tell how similar the stock follows the market in terms of volatility. This gives investors a general idea of the potential risk and return of an investment.
Disadvantages
Dependency on Historical Data – Due to beta’s reliance on historical price movements, it’s not a foolproof method of predicting future performance, especially during sudden market shifts or major events.
Single-Dimensional Measure – While beta allows investors to asses risk, it does not capture other important aspects of investment and shed light on where the risk comes from, such as company fundamentals, market risk, or company-specific risks.
Advanced uses of beta
Tactical Asset Allocation – Advanced investors sometimes employ beta in making strategic asset allocations based on macroeconomic indicators and market forecasts. For example, if there is higher risk in the broad market, investors can derail from the market by having heavy exposures on low-beta or uncorrelated bets or vice versa on bullish markets.
Analyzing Portfolio or ETF Risk – Advanced investors can also use beta to evaluate and adjust their exposure to different asset classes and optimize their portfolio by simply evaluating the beta of their portfolio, should they be exposed to ETFs or baskets of securities, beta can also provide a glimpse on the inherent risk on the fund or ETF.
Final thoughts
Beta is one of the vital tools investors can use in their investment strategies. This enables investors to assess risk, construct diversified portfolios, and make informed decisions. While it has its limitations, beta is still a valuable metric when combined with other forms of analysis that will fill in the gap on its limitations. Risks come in different forms, and recognizing them easily can help investors employ a consistently profitable yet low-risk strategy that can adapt to different sets of markets.
