What is Stock Beta and how can it be used to assess risk?

One of the most used metrics to analyze the risk of stocks is the Beta or the Beta coefficient (β). It is a measure of the volatility of a stock relative to the benchmark market or index.

To understand it, the market or benchmark has a Beta of 1 and individual stocks are ranked according to how much they deviate from the market.

If a stock that oscillates more than the market over time has a beta above 1. Conversely, if a stock moves less than the market, the stock’s beta is less than 1.

For example, a value with a Beta 1.63 will mean that it is 63% more volatile than the market. Likewise, a value with Beta 0.8 would be 20% less volatile than the market. Let’s imagine that the market is expected to rise 10%, and we identify a value with a Beta of 1.3. Because those stocks are 30% more volatile, a 13% rise would be expected..

Then there are isolated cases such as Beta 0, which means that the stock does not move and would be “risk-free” and when it is less than 0 indicates an inverse relationship to the market: goes up if the market goes down and vice versa.

Stocks with a high beta are riskier, but they offer a potential for higher returns and those that present a low Beta are less risky but also present a potential for low returns.

Your calculation

The Beta calculation is formed from the numerator which is the covariance of the asset in question, while the denominator is the variance of the market. These complicated sounding variables are simple in their calculation.

Beta Formula

Here is an example of the data you will need to calculate Beta:

  • Risk-free rate (typically Treasury bonds with at least two years).
  • Return on the security in question (generally one year to five years).
  • The performance of your benchmark over the same period as the security.

To show how to use these variables To do the Beta calculation, we will assume a risk-free rate of 2%, the rate of return on our shares is 16%, and the rate of return of the benchmark is 9%.

Start by subtracting the risk-free rate of return from both the security in question and the benchmark. In this case, the rate of return on our assets net of the risk-free rate would be 14% (16% – 2%). The same calculation for the benchmark would yield 7% (9% – 2%).

These two numbers, 14% and 7%, respectively, are the numerator and denominator of the Beta formula. Fourteen divided by seven yields a value of 2, and that is the Beta of this hypothetical value. On average, we would expect an asset with this Beta value to be 200% as volatile as the benchmark.

Leveraging Beta to Design Our Portfolio

By understanding the Beta we can now take advantage of it to structure our investment portfolio.

Because High Beta stocks rise more than the benchmark when markets are bullish and fall more than the market index when markets are bearish, a good portfolio would incorporate high beta stocks when the market outlook is positive and will look to add more low beta stocks when the market outlook is negative.

We can also assess it from the investor profile and portfolio time horizon. Investors with a low aversion to risk or young people with a long time horizon of their portfolio, will be less sensitive to high volatility and will seek higher returns with stocks with high Betas.

Profiles that are very conservative or that want to conserve their assets because the time horizon of their portfolio is very short, risk will tend to decline and the portfolio stocks will meet a low beta.

Like it? Share with your friends!


Your email address will not be published. Required fields are marked *