How does Beta reflect systematic risk?
Unlike unsystematic risk, diversification cannot help to smooth systematic risk, because it affects a wide range of assets and securities. For example, the Great Recession was a form of systematic risk; the economic downturn affected the market as a whole.
Beta and Volatility
Beta is a measure of a stock’s volatility in relation to the market. It measures the exposure of risk a particular stock or sector has in relation to the market. If you want to know the systematic risk of your portfolio, you can calculate its beta.
- A beta of 0 indicates that the portfolio is uncorrelated with the market.
- A beta less than 0 indicates that it moves in the opposite direction of the market.
- A beta between 0 and 1 signifies that it moves in the same direction as the market, with less volatility.
- A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility and is sensitive to systematic risk.
- A beta greater than 1 indicates that the portfolio will move in the same direction as the market, with a higher magnitude, and is very sensitive to systematic risk.
Assume that the beta of an investor’s portfolio is 2 in relation to a broad market index, such as the S&P 500. If the market increases by 2%, then the portfolio will generally increase by 4%. Likewise, if the market decreases by 2%, the portfolio generally decreases by 4%. This portfolio is sensitive to systematic risk, but the risk can be reduced by hedging.
Beta: Gauging Price Fluctuations
In investing, beta does not refer to fraternities, product testing or old videocassettes. In investing, beta is a measurement of market risk, or volatility – that pesky syndrome that makes some some people not want to invest in equities. These risk-averse investors can’t stomach stocks’ tendency to fluctuate in price. But they shouldn’t fear. Sure, there is always the possibility that a stock will lose some or all of its value, but volatility also makes it possible for investors to make a great deal of money – if they make the right choices.
What Is the Beta?
Beta measures a stock’s volatility, the degree to which its price fluctuates in relation to the overall stock market. In other words, it gives a sense of the stock’s market risk compared to that of the greater market’s. Beta is used also to compare a stock’s market risk to that of other stocks. Investment analysts use the Greek letter ‘ß’ to represent beta.
This measure is calculated using regression analysis. A beta of 1 indicates that the security‘s price tends to move with the market. A beta greater than 1 indicates that the security’s price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utilities sector stocks have a beta of less than 1, and conversely, many high-tech Nasdaq-listed stocks have a beta greater than 1.
Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return. Let’s give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let’s say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: A market return of 10% would mean a 5% gain for the company.
Here is a basic guide to various betas:
- Negative beta. A beta less than 0, which would indicate an inverse relation to the market, is possible but highly unlikely. However, some investors believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declines.
- Beta of 0. Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
- Beta between 0 and 1. Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.
- Beta of 1. A beta of 1 represents the volatility of the given index used to represent the overall market, against which other stocks and their betas are measured. The S&P 500 is such an index. If a stock has a beta of one, it will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.
- Beta greater than 1. This denotes a volatility that is greater than the broad-based index. Again, as we mentioned above, many technology companies on the Nasdaq have a beta higher than 1.
- Beta greater than 100. This is impossible, as it essentially denotes a volatility that is 100 times greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock market. If you ever see a beta of over 100 on a research site it is usually the result of a statistical error, or the given stock has experienced large swings due to low liquidity, such as an over-the-counter stock. For the most part, stocks of well-known companies rarely ever have a beta higher than 4.
Why You Should Know What Beta Is
Are you prepared to take a loss on your investments? Many people are not and therefore opt for investments with low volatility. Other people are willing to take on additional risk because with it they receive the possibility of increased reward. It is very important that investors not only have a good understanding of their risk tolerance, but also know which investments match their risk preferences.
And, by using beta to measure volatility, you can better choose those securities that meet your criteria for risk. Investors who are very risk averse should put their money into assets with low betas, such as utility stocks and Treasury bills. Those investors who are willing to take on more risk may want to invest in stocks with higher betas.
Many brokerage firms calculate the betas of securities they trade and then publish their calculations in a beta book. These books offer estimates of the beta for almost any publicly traded company. The problem is that most of us don’t have access to these brokerage books, and the calculation for beta can often be confusing, even for experienced investors.
However, there are other resources. One of the better websites that publishes beta is Yahoo! Finance (enter your company name, then click on Key Statistics and look under Stock Price History). The beta that is calculated on Yahoo! compares the activity of the stock over the last five years and then compares it to the S&P 500. A beta of “0.00” simply means that the stock either is a new issue or doesn’t yet have a beta calculated for it.
Warnings About Beta
The most important caveat for using beta to make investment decisions is that beta is a historical measure of a stock’s volatility. Past beta figures or historical volatility does not necessarily predict future beta or future volatility. In other words, if a stock’s beta is two right now, there is no guarantee that in a year the beta will be the same. One study by Gene Fama and Ken French, “The Cross-Section of Expected Stock Returns” (published in 1992 in the Journal of Finance) on the reliability of past beta concluded that for individual stocks past beta is not a good predictor of future beta. An interesting finding in this study is that betas seem to revert back to the mean. This means that higher betas tend to fall back towards one and lower betas tend to rise towards one.
The second caveat for using beta is that it is a measure of systematic risk, which is the risk that the market as a whole faces. The market index to which a stock is being compared is affected by market-wide risks. So, as beta is found by comparing the volatility of a stock to the index, beta only takes into account the effects of market-wide risks on the stock. The other risks the company faces are firm-specific risks, which are not grasped fully in the beta measure. So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks the company alone faces.
Let’s look at an old example. While numbers have changed significantly since 2005, this illustration still serves its purpose in describing the uses for beta. The following is a chart of IBM‘s stock for the trading period of June 2004 to June 2005. The red line is the IBM percent change over the period and the green line is the percent change of the S&P 500. This chart helps to illustrate how IBM moved in relation to the market, as represented by the S&P 500 during the one-year period.
Data Source: Barchart.com
On June 8, 2005, the beta for IBM on Yahoo! was 1.636, meaning that up to that point, IBM had the tendency to move more sharply in either direction compared to the S&P 500 – and the chart above demonstrates IBM’s tendency for higher volatility. When the market moved up, IBM (red line) tended to move up more (see the October-to-December range), and IBM’s stock fell more than the market when it declined (see the Jan-to-Mar range). The large drop in IBM stock from March to April 2005, while coinciding with a smaller drop in the S&P, resulted from a firm-specific risk: the company missed earnings estimates.
By showing IBM’s behavior over this period, this chart demonstrates both the value that comes with the use of beta and the caution that needs to be shown when using it. It helps measure volatility, but it is not the whole story.
The Bottom Line
We hope this has helped shed some light on an often-underestimated financial ratio. Analysts, brokers and planners have used beta for decades to help them determine the risk level of an investment, and you too should be aware of this measuring tool in your investment decision-making.