The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. Last month, we delved into alpha, and this month, we’re discussing another key measurement used to assess an investment: beta.
What is Beta?
Beta measures an investment’s volatility in comparison to the market as a whole, using an index like the S&P 500 as a benchmark for the market. The volatility it measures is systematic risk, meaning the risk inherent to the entire market as a whole. Investment values, like that of individual securities and portfolios, are measured and valued based on beta, which represents how they deviate from the market or benchmark index. Due to the nature of beta measuring volatility in comparison to a benchmark index, the stock, bond, or fund being assessed should be related to the benchmark index that is used in the calculating of beta to ensure the beta value is accurate and meaningful.
Beta, along with alpha, r-squared, the Sharpe ratio, and standard deviation, makes up the five primary indicators of investment risk to evaluate stocks, bonds, and mutual funds. These measures help predict investment risk and volatility and are all prominent components of modern portfolio theory, which is a methodology used to calculate the performance of investments via comparison to a market benchmark like the S&P 500. Modern portfolio theory aims to select investments based on the goal of maximizing overall investment returns within an acceptable and tolerable amount of risk. Overall, these five main risk measurements of modern portfolio theory, alpha and beta being two of those more prominently used indicators, help investors assess the risk-reward potential of investments.
Measuring and Evaluating Beta
The terms alpha and beta are often used when talking about investments and the evaluation of investment performance. These two terms are two different measures that are parts of the equation used to quantify/evaluate the performance of an investment like a stock or fund and compare and predict returns of investments. As we discussed in last month’s monthly jargon article, alpha represents the excess return on an investment relative to a benchmark index like the S&P 500. Alpha and beta are two of the five major risk management indicators for evaluating an asset’s past and predicted future performance. One way to look at these terms is that alpha shows investors whether an asset has steadily performed better or worse than an asset’s beta predicts.
Beta is used in the capital asset pricing model, known as CAPM. This formula defines the relationship between systematic risk – i.e. market volatility – and the expected return for an investment like a stock, bond, or mutual fund. The beta of a potential investment being a measure of how much risk the investment will add to a portfolio is why beta is an essential part of the CAPM, as the goal of the CAPM is to evaluate whether an investment is fairly valued when its risk – i.e. its beta – along with a few additional factors, is weighed in regards to the investment’s expected return. In other words, the CAPM formula indicates whether a stock, for example, is priced fairly relative to its risk, beta, to determine if the stock is a prudent and fair investment.
By the Numbers
Beta represents the tendency of an investment’s return to react to movements in the market. The market has a beta of 1.0. A beta of 1.0 indicates that an investment will move in tandem with the market, represented by a benchmark index. In accordance with 1.0 as the baseline, a beta of less than 1.0 denotes the investment will be less volatile than the market, while a beta of more than 1.0 indicates the investment will be more volatile than the market. For example, if a stock’s beta is 1.3, that stock is considered 30% more volatile than the market, meaning you would be assuming some risk if you choose to invest in that security. As another example, if a mutual fund’s beta is 0.8, that fund is considered to be 20% less volatile than the market. That being said, more conservative investors with a low-risk profile and investors looking to keep their capital steady should seek investments like securities and funds with low betas, while investors looking for high-risk-high-reward investment opportunities should look for securities and funds with high betas.
Final Points
Investors often tend to narrow-mindedly focus on investment returns, forgetting how important it is to factor in investment risk as well. Beta is one of the five major risk measures for a reason – it provides vital balance to the risk-return equation when it comes to properly evaluating an investment. That being said, keep in mind that volatility is only one of the factors you should be considering in terms of evaluating what can affect the value of an investment. Most importantly, take the time to do your research and due diligence before buying into a stock, bond, or fund. You want to make sure the investment fits your portfolio and overall diversification according to your risk profile, time horizon, and investment objectives.
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