Beta expresses the volatility of a security in relation to the market as a whole.
As previously mentioned in the page discussing volatility, the market is regarded as 1. The beta of any individual security is measured against the market and is therefore viewed in comparison to 1.
Essentially, it is a measure of sensitivity to market changes by a stock. This means that the stock can be assessed for risk in comparison to the market and therefore the national economy.
If a security has a beta of exatly 1, the moves of the market, both up and down, are reflected exactly by the security. By definition, this is a very rare occurence. It is, however, most likely to occur amongst the very largest companies since any move in price that they have has the biggest impact on the index. Equally, the index moving can have a big impact on their quoted price.
Should a company have a beta of more than 1, the price of the security is more volatile than the market. The movements of the company price exaggerate those of the market. Therefore, if the market rises, the company share price will rise faster. If the market falls, the share price will fall faster.
Less than 1 tells us that the price of a security moves less than the market but in the same overall direction. The security is therefore more stable in price than the overall market.
All this means that beta can provide a relative measure of risk compared to an index, a sector or a benchmark. It is calculated using monthly price movements over the proceeding 36 months.
Astute readers will recognise that this offers the potential - in theory at least if not always in practice - to balance a portfolio by holding companies that behave in opposing ways to those of the stock market as a whole.
Even more astute readers will recogise a further truth... Measurements such as beta enable the risk to be balanced in a portfolio, but that is a focus on capital preservation. For many investors - both private and professional - the aim is to do much more than preserve capital. Therefore, being able to select stocks with growth potential might be more important than risk mitigation.
This discussion is explored in more depth and detail in this interesting article which discusses the goals and measurements used by the fund management industry. As is rightly asked, if I manage your stock portfolio correctly and outperform our chosen index but the fund still loses money, is that acceptable?
This is, after all, one of the central precepts of the fund management industry - benchmarking against a relevant index. But, if the index falls by 20% in a calendar year and a fund that is compared against it only falls by 15% in the same time period, is that fund really a success? Losing money is still losing money, no matter how things compare when using beta to help analyse returns.
It is possibly for these reasons that the hedge fund industry has seen such rapid growth. Wealthy clients that understood that they wanted to make an actual profit every year preferred the concept of alpha and an absolute return.
What is it worth?
If such a fund does perform at -15% but it's benchmark fell at -20% in a year, an interesting issue is the payment for performance of the fund manager. After all, the fund manager has "outperformed" their target, so what should be a fair payment for such a result? Unfortunately, investment is a topic littered with such contradictions and conundrums.
Not so rich?
Another possibly interesting angle for readers to think about is the way in which terms such as volatility and risk impact their entire finances and net worth, rather than just their stock portfolio. This is a topic which has been explored in some depth by author Robert Frank in his book The High-Beta Rich, where he looks at the impact that borrowing has had on the finances of America's richest people.
He certainly finds some interesting correlations between a high value 'paper' net worth (probably held in stocks, or perhaps the ownership of one business) and the risks taken on when the owners of these assets borrow large amounts of money against these assets to live the lifestyle that they feel they deserve.
The risk is obviously that the value of their asset(s) could fall leaving them with large debts and minimal security. Often such people (company founders, for example) have a strong sense of self belief in their knowledge and skills, meaning that they feel secure in having their assets in a highly concentrated form such as their own business.
However, there are outside factors (business and economic) that can cause the value of that one asset to fall substantially. This is even more of a pronounced risk if the company is quoted on a stock market somewhere. Technologists call this a single point of failure.
If nothing else, such a book makes the reader think carefully about the impact of borrowing to fund lifestyle needs.
For more pages relating to this topic, go to:
Understanding A P/E Ratio (Price To Earnings Ratio)