What Is Beta?
Beta (β) is a measurement of volatility of a specific security or portfolio, relative to a specific market, such as the S&P 500.
How To Calculate Beta
Fortunately for investors, a public security’s beta is widely available on a variety of financial websites. However, in order to understand the applications of beta, one must first understand what beta is. As stated before, beta measures volatility relative to a general market. By measuring historical returns, relative to the market, beta shows investors how a security, or portfolio, responds to moves by the general market. This concept of volatility is quantified by calculating beta using the formula below.
β = Cov(Ri,Rm) / Var(Rm)
Where
β: Beta
Cov: Covariance
Var: Variance
Ri: Return on the asset or portfolio
Rm: Return on the general market
Analyzing Beta
After calculating the beta of a security, it will be 1, less that 1, greater than 1, or less than 0. It is important to understand what this result implies. A security or portfolio with a beta of exactly 1 is very correlated to the general market and can be expected to produce similar levels of volatility. A beta less than one indicates a security or portfolio which is less volatile than the general market. A beta greater than one is of course, more volatile than the general market. A portfolio or a security with a beta less than zero is inversely correlated to the market. A short ETF is engineered to have a negative beta. In theory, a stock with a beta of 2, for example, would move 2% if the general market moves 1%.
Beta Utilities
Beta’s utility as a stand-alone metric is limited. However, beta is very important to the capital asset pricing model. In this model, beta is vital to the calculation of cost of equity. In its calculation, cost of equity utilizes beta as a measure of risk. Beta is also used in risk management by portfolio managers.
Limitations Of Beta
As a measure of a security’s intrinsic risk, beta is insufficient. By solely viewing risk through volatility of market price, beta ignores much more important risk factors such as a company’s financial situation, economic pressures, and industry developments. As a measure of volatility, beta may only prove useful in the short term. Beta measures past performance, a security’s volatility is subject to change with the progression of time thus rendering beta as an insufficient forecaster of future developments.