Beta (β) is a measure of the volatility or systematic risk of a security or portfolio compared to the market as a whole (typically the S&P 500). Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and the expected return on assets (typically stocks). Let's see what the Beta coefficient is and how it helps us in our investments.
What is the beta coefficient?
Beta (β) is a measure of volatility or systematic risk of a security or portfolio compared to the market as a whole (typically the S&P 500). Securities with betas greater than 1,0 can be interpreted as more volatile than the S&P 500. Beta used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and the expected return of assets (usually actions). The CAPM is widely used as a method to to price risky securities and to generate estimates of the expected return on assets, taking into account both the risk of said assets and the cost of capital.
What is the beta coefficient for?
The beta is used to trying to gauge how much risk a stock adds to our portfolio. While a stock that deviates very little from the market doesn't add much risk to a portfolio, it also doesn't increase the potential for higher returns. To ensure that a particular stock is being compared to the correct benchmark, it should have a high R-squared value relative to the benchmark. R-squared is a statistical measure that shows the percentage of a security's historical price movements that can be explained by movements in the benchmark index. When beta is used to determine the degree of systematic risk, a security with a high R-squared value, relative to its benchmark, may indicate a more relevant benchmark.
Comparison of the beta coefficient of Accenture (ACN) against its competitors over the last 5 years. Source: Finbox.
How is the beta coefficient used?
A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market. In statistical terms, beta represents the slope of the line through a regression of data points. In finance, each of these data points represents the returns of an individual security against those of the market as a whole. Beta effectively describes the activity of a security's returns in response to market swings.
How to calculate the beta coefficient?
Calculating beta is used to help investors understand whether a security is moving in the same direction as the rest of the market. It also provides information about the volatility or risk of a security in relation to the rest of the market. For beta to provide useful information, the market being used as a reference must be related to the security. For example, calculating the beta of a currency ETF using the S&P 500 as a benchmark would not provide much useful information to an investor, because bonds and stocks are too different. The beta of a security is calculated by dividing the product of the covariance of the return on value and the profitability of the market for variance of the market profitability during a certain period.
Formula and values for calculating the beta coefficient.
What should be taken into account about the beta coefficient?
There are a couple of important considerations to keep in mind when using beta. This is because we can find different types of beta values, which we will list below:
- Beta value equal to 1,0: A beta equal to 1,0 tells us that its price activity is strongly correlated with the market. A security with a beta of 1,0 has systematic risk. However, beta calculation cannot detect any unsystematic risk. Adding a stock to a portfolio with a beta of 1,0 does not add any risk to the portfolio, but it also does not increase the probability that the portfolio will provide excess returns.
- Beta value less than 1,0: A beta less than 1,0 means the security is theoretically less volatile than the market. Including this security in a portfolio makes it less risky than the same portfolio without the security. For example, utility stocks typically have low betas because they tend to move more slowly than market averages.
- Beta value greater than 1,0: A beta greater than 1,0 indicates that the security's price is theoretically more volatile than the market. For example, if a security's beta is 1,2, it is assumed to be 20% more volatile than the market. This indicates that adding the stock to a portfolio will increase the risk of the portfolio, but it may also increase its expected return.
- Negative beta value: A beta of -1,0 means the stock is inversely correlated with the market benchmark at a 1:1 ratio. This action could be considered as a reference value. This value could be considered as an opposite and mirror image of the trends of the benchmark index.