Last Updated on 12 June, 2021 by Samuelsson
Risk is one thing you cannot avoid in financial trading; you only have to know how to measure and manage it to be able to attain the trading success you desire. Without understanding risk and creating a way to manage it, you will end up losing more than you can tolerate or even lose everything. Each asset has its own level of risk, and fortunately, you can use beta to evaluate that risk. Now, you may be wondering: what is beta in trading?
In financial trading, beta is defined as the measure of volatility (also known as the systemic risk) in a security or portfolio relative to the overall market. Beta is an important component of the capital asset pricing model (CAPM), which establishes the relationship between systematic risk and expected return for assets. A security that has a higher beta has more risk and therefore is expected to offer more returns.
In this post, our focus is on the beta, and we will be discussing it under the following headings:
- What is Beta?
- Understanding beta in trading?
- Importance of Beta
- Limitations of Beta
- Levered beta vs unlevered beta
What is Beta?
Beta is a statistical measure of the volatility — also known as systematic risk — of a financial asset or portfolio relative to the market as a whole. In the stock market, investors use beta to compare the volatility in the price of a stock to those of the overall market. Volatility, here, refers to how big and fast the price swings in either direction. In other words, it refers to price fluctuations around its initial mean value.
The volatility of the broad market index, such as the S&P 500 index, is given a beta value of 1.0. Volatility in individual stocks is compared to that of the market index, such that those with higher volatility have beta values greater than 1.0, and those with less volatility are given beta values less than 1.0. A beta value of zero shows a lack of correlation to the market, while a negative beta shows an inverse relation to the market. To many investors, gold has a negative beta because it tends to do well when there’s a stock market crash.
Generally, investments with high beta values are assumed to be riskier, and in the CAPM, they are expected to offer a higher return potential. On the other hand, low-beta assets have less risk, so they are expected to offer lower returns. The idea is that any security that fluctuates less than the market over time is likely to offer lower returns than the general market, but the one that has higher swings is likely to make more returns over time. However, this does not consider the opposite swing, which increases drawdowns rather than returns.
Nonetheless, by using beta to assess the systemic risk of different securities, investors and traders can find securities that meet their specifications. For a risk-averse investor, it’s highly advisable to invest in securities with low betas, such as treasury bills.
What is a stock’s beta?
A stock’s beta is a measurement of its volatility (systemic risk) compared to that of the overall stock market. This means that a stock’s beta shows the degree to which the price of a stock tends to fluctuate up and down. Beta effectively describes how a stock moves when compared to the swings in the market.
Hence, from a stock’s beta coefficient, you can know how volatile the stock is compared to the entire market. In essence, you know how much systematic risk you are exposed to when investing in that stock compared to what is obtainable in the overall market. For example, if Tesla (TSLA) has a beta of 1.5, it means that its volatility, or systemic risk, is about 50% more than that of the S&P 500 Index — or if you like, the Nasdaq composite index.
Since beta is an input in the capital asset pricing model (CAPM), where the expected return of an asset is calculated based on its beta (ß), you use the beta value of any stock to calculate the expected returns for that stock.
The capital asset pricing model
Every investor wants to be compensated for any extra risk taken. If there’s no expectation for a higher return, no one would want to assume any extra risk by investing in a security with a higher risk than the overall market; everyone would simply invest in a passive fund that tracks the movement of the broad market index. The CAPM was developed to describe the relationship between the risk assumed when investing in a security and the expected return from that security.
The capital asset pricing model (CAPM) is a model developed by award-winning economists to show the relationship between the systematic risk of an asset and the expected return of investing in an asset. CAPM is mainly used in financial investments for pricing risky securities and estimating their returns using their risks and cost of capital.
In estimating the return of a particular stock, the Capital Asset Pricing Model (CAPM) uses the concept of beta. Therefore, beta is the crucial factor in the Capital Asset Price Model (CAPM) since the systematic risk of the stock can be evaluated by calculating beta. Overall, the CAPM shows that the expected return on a security is equal to the risk-free return plus a risk premium based on the beta of that security.
Understanding Beta in trading
Beta is a numeric value that indicates the level of fluctuations of a security (stock) compared to the level of volatility in the overall stock market. The value is gotten by dividing the covariance of the security’s returns and the market’s returns by the variance of the market’s returns over a specified period.
The beta of a financial asset tells an investor the amount of systemic risk he would assume by investing in the asset compared to if he had invested in a passive fund that tracks the market’s benchmark index. The benchmark is already assumed to have a beta of 1.0, so relative to it, other assets can either have a higher beta or a lower one depending on how much more volatility (risk) they have. The more the beta value, the more the expected returns. Let’s take a look at how to interpret beta.
Interpreting different beta values
Source: Corporate Finance Institute
Beta value equal to 1.0
When a stock or a fund has a beta value of 1.0, it entails that its price fluctuations closely mimic that of the market benchmark. So, adding a security to your portfolio does not add any risk above that of the market benchmark, and as such, it is not expected to offer extra returns above that of the market benchmark.
Beta value less than 1.0
A beta value that is less than 1.0 indicates that the asset is less volatile than the market benchmark index. When you have a portfolio of such an asset, you would be assuming less risk than the market, but your expected returns would also be lower. Utility stocks tend to have low beta values.
Beta value greater than 1.0
A security that has a beta value of more than 1.0 has higher price volatility than the market benchmark index. So, a security can increase the risk of your portfolio, but it comes with higher expected returns. For example, a stock with a beta value of 1.2 is estimated to be 20% more volatile than the general market, but it is also expected to yield more returns to compensate for the extra risk.
Beta value less than 0 (negative beta value)
The beta value of a financial instrument can also be negative. A negative beta value indicates that the asset’s price maintains an inverse relationship with the market. A security with a beta value of -1 is considered to be inversely correlated to the market benchmark.
Beta value equals zero
If the fluctuations in an asset do not correlate with that of the benchmark, the beta value would be zero because the covariance of the asset’s returns with the market’s returns would be zero.
How is beta calculated?
The beta of a security can be calculated using various methods: Covariance Method, Correlation Method, Slope Method, and more. However, the most common method for calculating beta is the beta formula:
Beta = Covariance/variance.
Covariance = measure of a stock’s return relative to that of the mark
Variance = measure of how the market moves relative to its mean
With this method, you divide the covariance of the return of the market and the return of the asset by the market return’s variance over a given timeframe. Thus, the covariance between the return of the security and the variance of the market returns are essential variables that must be known before calculating the beta of a security using the Covariance method.
Let us start by explaining the following terms:
- Variance: Variance refers to the degree of variation in the price of a security — that is, how far a security’s price moves relative to its mean. It is used in measuring the volatility of a security’s price over time.
- Covariance: This is used to measure the correlation in price moves of two different securities. It measures how the price movements of two securities are related. When the covariance is positive, it means that the two securities move together when their prices go up or down. However, a negative covariance means the securities move in the opposite of each other.
In the case of beta, you need the covariance of the return of the security under review with the benchmark’s return, as well as the variance of the benchmark’s return over the period under review.
How to calculate a beta coefficient
The beta coefficient is an essential input in the capital asset pricing model (CAPM). A beta coefficient tells you how sensitive a financial asset is to movements in the overall market. Using the CAPM, a security’s required rate of return, also known as cost of equity, can be calculated by summing the risk-free interest rate and the asset’s equity risk premium. The equity risk premium is the product of the asset’s beta coefficient and the market risk premium or the difference between the broad market return and the risk-free interest rate.
Cost of Equity (CAPM)
= Risk-Free Rate + Equity Risk Premium
= Risk-Free rate + Beta × Market Risk Premium
= Risk-Free Rate + Beta ×: (Market Return – Risk-Free Rate)
Since covariance is the product of the standard deviation of the stock returns, the standard deviation of the market returns, and their correlation coefficient, we can derive another formula for calculating the beta coefficient: beta coefficient equals the correlation coefficient multiplied by the standard deviation of stock returns divided by the standard deviation of market returns.
β = Correlation Coefficient × Standard Deviation of Stock Returns
Standard Deviation of Market Returns
For example, if the correlation coefficient between market returns and returns on the stock of Company P is 0.85, the standard deviation of the market is 10%, and that of stock is 8%, you can calculate the beta coefficient as follows.
β = Correlation Coefficient × Standard Deviation of Stock Returns
Standard Deviation of Market Returns
β = 0.85 x 8%
= 0.85 x 0.08
The beta coefficient of 0.68 is less than one, which indicates that the asset has less volatility than the market, and it is also expected to yield lower returns than the market.
Let’s look at another example using the covariance method: Assuming an investor is looking to calculate the Beta of Tesla (TSLA) relative to SPY, and based on recent five-year data, TSLA and SPY have a covariance of 0.032. The variance of SPY is given as 0.015.
You can calculate the beta as follows
TLSA’s beta = 0.032
The beta value of 2.13 for TSLA means that the asset is theoretically 113% more volatile than SPY (the market). So, it carries more risk and, therefore, is expected to offer more returns.
How to calculate the beta of a portfolio?
Beta is measured with reference to a market index like the S&P 500 Index. For instance, a beta of 1.0 indicates that its volatility is the same as the benchmark, while a beta value above 1.0 shows more volatility than the benchmark.
Since an investment portfolio usually consists of many assets, the volatility of a portfolio is calculated using the weighted average method. This involves calculating the beta of each asset in the portfolio, and then, you take the weighted average of the betas of all assets to get the beta of the portfolio.
For example, a portfolio contains three stocks: A, B, and C, with portfolio weights as 10%, 30%, and 60%, respectively. If the beta of these three stocks is 1.1, 1.3, and 0.8, then the portfolio beta will be:
Portfolio beta = 1.1*10%+1.3*30%+0.8*60% = 0.98
How to calculate beta of individual stocks?
There are times when you may need to calculate the beta of individual stocks to get an idea of how the stock is contributing to your overall risk exposure. However, there are things you should consider:
First, you should understand that beta can be calculated over different timeframes: a stock may be volatile in the short term but stable in the long term.
Second, in calculating the beta of individual stocks, you may need to use different benchmarks. For example, a stock with a heavy presence overseas is best judged against an international index instead of the S&P 500 Index.
To calculate the beta of an individual stock, you will need a spreadsheet. In the spreadsheet, enter the closing share price for your stock on each day of the date range you’ve selected. Then do the same thing for the index you are comparing against. For each date, determine the change in price and the change on a percentage basis.
Then plug in the formula to determine how the stock and index move together and how the index moves by itself.
The formula for calculating the beta of an individual stock is given as:
(Stock’s Daily Change % x Index’s Daily % Change) ÷ Index’s Daily % Change
Importance of Beta
It is important to consider a stock’s price variability when assessing risk. Fortunately, beta acts as a proxy for risk. Here are some of the uses:
- Beta can help an investor to easily assess his portfolio’s risk. Different stocks in a portfolio have different betas, but the portfolio’s beta can be gotten by taking a weighted average of the betas of the component stocks. To arrive at a target beta for the portfolio, the portfolio manager can add or delete certain stocks from the portfolio.
- Beta can be used to evaluate and compare the risks involved in different funds so as to know the one to invest in
- It’s a convenient measure that can be used to calculate the costs of equity used in a valuation method.
Limitations of Beta
While beta may be useful in estimating the risk of an asset, it has many limitations, and we will take a look at them one by one.
1. Equity returns are not normally distributed
The beta theory assumes that returns on any asset are normally distributed statistically. But we all know that is far from being true: financial markets are prone to large surprises, and returns aren’t always normally distributed. So, what beta says about future price movement may not always be true.
For instance, a stock in a long-term downtrend could have small price swings and so give a very low beta. Adding such a down-trending stock with a low beta can reduce risk in a portfolio theoretically if we define risk strictly in terms of volatility, but in reality, risk is the potential for losses. So, this low-beta stock in a downtrend is more likely to lead to more losses than improve the performance of the portfolio. On the other hand, a high-beta stock that is volatile but in an uptrend will, in theory, increase the risk of a portfolio, but in reality, it adds gains because it is trending higher.
As a result, it’s recommended that investors who want to use beta to evaluate a stock should also use fundamental or technical analysis to evaluate the stock before assuming it will add or reduce risk from their portfolio.
2. Beta does not distinguish between upside and downside price movements
For most investors, downside movements are a risk, while upside ones mean opportunity. However, beta doesn’t distinguish between upside and downside price swings. It simply assumes greater volatility to mean greater risk and vice versa, without considering whether the price swing is in the trader’s favor.
3. Beta is not futuristic
Beta is calculated using historical data points, making it less meaningful for investors looking to predict a stock’s future movements.
Moreover, where the stock is new, there would be fewer data to use for the analysis. For example, most technology stocks are new to the market, leaving the investor with less information to establish reliable data.
4. Beta is best suited for short-term investments only
Beta works best in the short term where volatility, especially downside volatility can pass for risk. In long-term investments, a stock’s volatility can change significantly from year to year, depending upon the company’s growth stage and other factors.
Levered beta vs. unlevered beta
Levered beta, also known as equity beta, is a measure of risk that includes the impact of a company’s capital structure and leverage. It includes both business risk and the risk that comes from taking on debt and shows how sensitive a security might be to macro-market risks. For example, a company with a β of 1.3 denotes returns that are 130% as volatile as the market it is being compared to.
The higher a company’s debt or leverage, the more earnings from the company that is committed to servicing the debt. However, since different firms have different capital structures, unlevered beta is calculated to remove additional risk from debt to view pure business risk.
The levered beta can be calculated using the formula below:
Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))
The unlevered beta, on the other hand, captures the risk of the company’s assets only after removing the financial leverage.
The formula for calculating the unlevered beta is given as:
Unlevered β = Levered β / ((1 + (1 – Tax Rate) * (Debt / Equity))
Risk assessment is an important aspect of any investment, and beta offers an easy way to measure risk. However, the beta has a lot of limitations, which you need to be aware of. Always combine it with other forms of analysis, such as fundamental and technical analysis when making an investment decision.