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Understanding Beta and Market Risk

By: Investor Solutions

By: Investor Solutions, Inc.

The only “sure thing” in investing, is that market risk can never be eliminated no matter how much you diversify. Risk is a four letter word that every knowledgeable investor should be familiar with. In fact, portfolio returns are really meaningless if there is no regard to portfolio risk, as measured by standard deviation. The risk, however, of a well diversified portfolio depends entirely on the risk of the individual securities included in that portfolio, as measured by beta. This article will focus on understanding the impact of market risk and the measure of market risk known as “beta”. Is this really a good tool for investors to use?

Every portfolio has two types of risk embedded in it: diversifiable (non systematic) risk and non-diversifiable (systematic) risk. Global diversification across unique asset classes goes a long way towards risk control. However, the prevalent source of uncertainty in an investor’s portfolio is the risk that is tied into the market (the risk of just being in it). While this risk can never go away, it can, however, be measured so that investors can make better decisions.

Adding individual securities into a portfolio for the sake of diversification offers little benefit if you neglect to measure its sensitivity to the market as a whole (we can use the S&P 500 as a benchmark for U.S. securities). Intelligent investors ought to consider how closely that security might track to the market. This measure of sensitivity is known as beta (²). Beta is a measure of co-movement, not risk. Instead, it is a relative risk measurement tool.

The higher the correlation between the security and the market (as measured by R2), the more meaningful is beta. A beta of 1.0 means that for every 1% change in the market, an individual security or investment will likely move 1%. In other words, it tracks directly with the market. Stocks with betas greater than 1.0 have more amplified movements than the market itself; they have a greater level of risk. A beta, for example, of 1.4 implies that an investment’s returns will likely be 1.4 times as volatile as that of the market. A beta of less than 1.0 means that the security moves in the same direction as the market, but not as far as the market. For example, a beta of .85 means that the security is 15% less volatile than the market.

We can also measure the stocks in foreign countries in the same way. The only difference is the individual security risk is measured against the stock’s home market (not the S&P 500).

A Review of CAPM

The higher the beta, the higher the risk. Therefore, to justify the extra risk, investors should expect a higher return on that security. Bill Sharpe’s Capital Asset Pricing Model (CAPM) looks at risk and rates of return and compares them to the overall market. This theory suggests that the expected return of a security (or a portfolio) equals the risk free rate (i.e. Treasury bill) plus a risk premium. To calculate how much extra return you should take to compensate for that risk, you can use the following CAPM formula:

Required Return = Risk free rate + (Market return – Risk free rate) * Beta

So, assuming a risk free rate of 3% and a market rate of 8%, for a company with a beta of 1.4, the investor should demand a rate of return equal to 10% {3+(8-3)*1.4}. Swap that for a company with a beta of 2.8 and the required return shoots to 17%.

As I mentioned in the introduction, the risk of a portfolio depends upon the risk of the individual securities (which we’ve just learned). We can now discuss the impact on the portfolio as a whole. The beta of a portfolio is the weighted average of the individual asset betas where the weights are the portfolio weights.

Portfolio Beta = (the sum of) £ {weight of security X Beta of security}

So, investors can construct portfolios with whatever beta they want, since all the information they need is the betas of the underlying assets. But, unfortunately the CAPM approach is flawed for many reasons including but not limited to:

  • The beta may not be constant through time.
  • The world CAPM may not hold in all countries.
  • The returns on the market portfolio and the risk free rate may be wrong
  • There may be other sources of risk (as explained in the Fama/French 3 Factor Model)

Renowned academics Eugene Fama and Ken French suggest that three risk factors: market, size and price dimensions explain 96% of historical equity performance. This model explains the fact that two particular types of stocks outperform markets on a regular basis: value and small-caps. They proved that this pattern persists in multiple time frames and every global market where we can assemble data. A far superior model than CAPM, the Fama-French Three Factor Model allows investors to calculate the way portfolios take different types of risk in order to calculate their appropriate expected returns. It has replaced CAPM as the accepted model for determining expected returns.

To recap, the Beta Coefficient is determined by several factors: the variability of the individual stock return, the variability of the market return, and the correlation between the return on the security and the return on the market. Because beta is based on the historical performance of a stock, it should not be used as an indication of how the stock may perform in the future. Furthermore, the CAPM model which employs Beta is not the best model for investors to use and only tells part of the story. Instead, investors would be well served to explore the benefits of the alternative 3 Factor Model.