By Eric Peters, Fall 2017 IAC Student Intern
Beta, the measure of a stock’s tendency to move up and down with the market, is the most relevant measure of any stock’s risk. Individual investors generally hold portfolios rather than the stock of only one company because the risk of an asset held as part of a portfolio is less risky than the same asset held in isolation. Combining stocks into portfolios reduces risk, but does not completely eliminate it.*
A stock’s risk consists of two components: 1.) diversifiable risk and 2.) market risk. The key difference between these two measures of risk is that diversifiable risk can be reduced or substantially eliminated, while market risk cannot. Therefore, when creating or evaluating your portfolio, it is important to understand and consider these two types of risk to ensure that your portfolio matches your risk aversion and return expectations.
First, let’s define the two types of risk:
- Diversifiable Risk– the risk unique to a company or asset that can be reduced or eliminated by holding a portfolio of uncorrelated assets. Specifically, positively correlated stocks would not diversify a portfolio because they move up and down together. Therefore, a portfolio of only correlated stocks would do nothing to reduce portfolio risk. Essentially, the risk of one stock can be offset by also holding an uncorrelated, less risky stock that reduces some of the risk present in the riskier stock. Thus, the risk and return of an individual security should be analyzed in terms of how that security affects the risk and return of the portfolio in which it is held. For example, by adding a company’s stock that earns money in recessions, such as a collection agency, when most other companies’ earnings tend to decline, will stabilize the returns on the entire portfolio, thus making the portfolio less risky.
- Market Risk– the risk created by general movements in the stock market, reflecting the fact that most stocks are systematically affected by general market events such as war, recessions, inflation, and high interest rates. Since most stocks are negatively affected by these factors, market risk cannot be eliminated by diversification. Since an investor can significantly eliminate the diversifiable risk present in his or her portfolio, the most relevant measure of a stock’s risk is market risk.
This is where beta comes in.
Beta is defined by the Federal Reserve as the correlation of a stock’s risk to the average market risk during a given period, as measured by some index such as the Dow Jones Industrials, the S&P 500, and the New York Stock Exchange Composite Index. This correlation is expressed in a number called the “beta coefficient,” or “b.” This number can mean different things, and it is important for investors to understand its meaning when it arises.
- If b = 1.0, the stock is about as risky as the market.
- If b < 1.0, the stock is less risky than the market.
- For example, if b = 0.5, the stock is half as risky as the market.
- If b > 1.0, the stock is more risky than the market.
- For example, if b = 2.0, the stock is twice as risky as the market.
Now, at this point you might be asking yourself why beta matters to you. The answer is that it is an excellent, all-in-one representation of risk. Remember, since a stock’s diversifiable risk can be reduced or substantially eliminated by holding other safer, less risky assets in your portfolio, a stock’s market risk (measured by beta) is the truest representation of risk. A very important feature of beta is that the beta of a portfolio is a weighted average of its individual securities’ betas. Thus, the beta of your portfolio can determine the overall risk of your portfolio’s position. Therefore, by using beta as a benchmark to measure portfolio risk, you can better position your holdings to match your level of risk aversion and return expectations.
*I learned a lot about this topic from the textbook Intermediate Financial Management.
Check it out if you would like to learn more: Brigham, Eugene F. and Daves, Phillip R. (2010). Intermediate Financial Management. Ohio: South-Western Cengage Learning.