How Does Beta Measure a Stock’s Market Risk?

Also, a company with a β of 1.30 is theoretically 30% more volatile than the market. Similarly, a company with a β 0f 0.79 is theoretically 21% less volatile than the market. Beta is calculated using two specific components, covariance and variance.

What is a good beta for a stock?

The calculation helps investors understand whether a stock moves in the same direction as the rest of the market. It also provides insights into how volatile–or how risky–a stock is relative to the rest of the market. Levered beta includes both business risk and the risk that comes from taking on debt. However, since different firms have different capital structures, unlevered beta is calculated to remove additional risk from debt in order to view pure business risk. The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued.

Sure, there are variations on beta depending on things such as the market index used and the time period measured. It’s a convenient measure that can be used to calculate the costs of equity used in a valuation method. A stock’s price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

The R-squared value measures the percentage of variation in the share price of a security that can be explained by movements in the benchmark index. For example, a gold ETF will show a low β and R-squared in relation to a benchmark equity index, as gold is negatively correlated with equities. The first, and simplest, way is to use the company’s historical β or just select the company’s beta from Bloomberg. The second, and more popular, way is to make a new estimate for β using public company comparables. To use the comparables approach, the β of comparable companies is taken from Bloomberg and the unlevered beta for each company is calculated. Asset beta, or unlevered beta, on the other hand, only shows the risk of an unlevered company relative to the market.

Related Terms

Positive covariance suggests that the prices of the two stocks will likely move in the same direction. Conversely, a negative covariance indicates that the value of the two stocks moves in opposing directions. Usually, one of the stock prices used in covariance comes from a specific market index like the S&P 500. It is calculated using two specific components, covariance and variance. Unlevered beta, or asset beta, also assesses the performance of a security in response to market fluctuations. Traders can add additional filters, such as country, exchange, and index.

Relationship between own risk and beta risk

This value represents Alpha, or the additional return expected from the stock when the market return is zero. Large changes in macroeconomic variables, such as interest rates, inflation, GDP, or foreign exchange, are changes that impact the broader market and that cannot be avoided through diversification. The Beta coefficient relates “general-market” systematic risk to “stock-specific” unsystematic risk by comparing the rate of change between “general-market” and “stock-specific” returns. Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is riskier than it was before it fell. Beta says nothing about the price paid for the stock in relation to fundamental factors like changes in company leadership, new product discoveries, or future cash flows. A company behind the next big thing typically commands a high valuation.

Systematic vs Unsystematic Risk

There are two securities, Mcdonald’s stock & Wall Street Oasis security, with returns of -8%, 5%, and 13% for A and -4%, 5%, and 17% for B. So in more general terms, the Beta Coefficient usually has a range of 0-1+. It would help if you always viewed a Beta of 1 as the neutral point in volatility since it equals the market. So any less or more gives forex commodities indices cryptos etfs you a good idea of whether your investment will have more or less risk. These estimators attempt to uncover the instant prevailing market-beta.

1. Put options and inverse ETFs are designed to have negative betas, which means they track the opposite of the benchmark’s trends.
2. In finance, each point represents an individual stock’s returns against the market.
3. Interpreting beta coefficients involves understanding both their magnitude and sign.
4. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.

To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known as well as the variance of the market returns. The covariance of the return of an asset with the return of the benchmark is divided by the variance of the return of the benchmark over a certain period. In the world of finance, beta is a fundamental tool for assessing risk and making informed investment decisions. By understanding beta’s significance, calculation, and application, investors can build portfolios that align with their risk tolerance and financial objectives. Whether you are a seasoned investor or just starting, beta is a crucial concept to master as you navigate the complex landscape of financial markets. Investors considering active or passive investment strategies should understand the role of beta.

In other words, it is a measure of risk, and it includes the impact of a company’s capital structure and leverage. Equity beta allows investors to assess how sensitive a security might be to macro-market risks. For example, a company with a β of 1.5 denotes returns that are 150% as volatile as the market it is being compared to.

Changing from the previous question, suppose you have an average return of 9.12% in Security A with a Beta of 0.53. Unfortunately, the return for the government T-Bill has been torn off by your dog because you were day trading and you forgot to feed him. However, notice how the Treasury Bill has the smoothest figure compared to any other market, such as the Small Company Stocks. This also represents that a riskless investment will ensure almost no loss risk. Attempts have been made to estimate the three ingredient components separately, but this has not led to better estimates of market-betas. Take crypto market news and analysis from etoro self-paced courses to master the fundamentals of finance and connect with like-minded individuals.

Now let’s take a step back and first look at why Beta is even used when we want to assess the risk of an investment. As a general rule of thumb, the greater the risk on an investment, the greater the rewards & losses. However, in some cases, a stock’s Beta is less than 0, which would indicate an inverse relation to the market, as mentioned a beginners guide to algorithmic thinking above, is possible but highly unlikely to occur.

When long-term market-betas are required, further regression toward the mean over long horizons should be considered. There is a lot of hope baked into its share price, resulting in wild swings whenever it fails/exceeds expectations and a five-year beta of 2.41, as of June 2024. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. 11 Financial is a registered investment adviser located in Lufkin, Texas.

The beta (β) of an investment security (i.e., a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns. It can show the relationship between a hedge fund’s returns and the market return. Beta can show how much risk the fund is taking in certain asset classes and can be used to measure against other benchmarks, such as fixed income or even hedge fund indexes.

Think of an early-stage technology stock with a price that bounces up and down more than the market. It’s hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta. The overall market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. For example, the β of most technology companies tends to be higher than 1.

Both beta and correlation are essential for investors to incorporate into their investments. In fund management, adjusting for exposure to the market separates out the component that fund managers should have received given that they had their specific exposure to the market. This is measured by the alpha in the market-model, holding beta constant. In the graph above, we plotted excess stock returns over excess market returns to find the line of best fit. However, we observe that this stock has a positive intercept value after accounting for the risk-free rate.