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In this post, I will be providing a thorough explanation on the concept of Beta, and why it's important to consider the Beta value when investing in stocks.
Definition
Beta is a measure of the volatility , or systematic risk, of a security or portfolio compared to the market as a whole. It is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for stocks.
For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation.
However, a text-book definition of the concept does not really help us understand what Beta is
How to calculate the Beta
- To begin with calculating the value, we must first start by spotting the price change of a certain stock in comparison to the market's movement
- After a certain period, we collect enough data (grey dotted points), allowing us to plot a trend
- With this, we can figure out the relationship between the profitability of the stock we are looking at, and that of the market
- Based on the data, we calculate the Beta by dividing the product of the covariance of the stock's returns and the market's returns by the variance of the market's returns over a specified period.
Explained Through Examples
- We can consider 3 types of stocks:
- Stock 1 with a Beta value of 1
- Stock 2 with a Beta value of 0.5
- Stock 3 with a Beta value of 1.5
- We assume that these stocks are all listed on NASDAQ, and the NASDAQ Composite Index (IXIC) moved up by 10%
- Stock 1, which has a Beta value of 1, will show the exact same movement paired to that of the market. It reflects 100% of the market's movement
- Stock 2, on the other hand, reflects only half of the market's movement, with a Beta value of 0.5 Thus, it moves up by 5%
- Stock 3, moves up by 15% as it has a beta value of 1.5, moves up more drastically than the market value, indicating that the stock is more volatile
Four Possible Cases for Beta Values
- We can consider four possible cases for Beta values:
Beta Value Equal to 1
In this case, the security (stock) shows a strongly correlated movement with the market movement. Examples of such securities include Exchange Traded Funds (ETFs) such as QQQ which track the Nasdaq 100 index .
Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.
Beta Value Less Than 1
A beta value that is less than 1 means that the security is theoretically less volatile than the market.
Having a stock with such beta value helps make a portfolio less exposed to risk. Utility stocks often have low betas because they tend to move more slowly than market averages.
Beta Value More Than 1
A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market.
As in the example above, if a stock's beta is 1.5, it is assumed to be 50% more volatile than the market. Tech stocks tend to have higher betas than the market benchmark.
Having a stock with such beta value exposes the portfolio to more risk, but also higher potential returns as well.
Negative Beta Value
A security with a negative Beta value means that the stock is inversely correlated to the market benchmark.
Prime examples of such securities are inverse ETFs, and certain industry groups such as precious metal mining companies, where a negative beta value is commonly found.
Real Life Examples
- Based on the explanation above, we can now move on to the following examples of stocks listed on NASDAQ for real life examples: Lulu Lemon (LULU), Tesla Motors ( TSLA ), Amazon ( AMZN ), Costco (COST), ProShare UltraPro Short QQQ ETF ( SQQQ )
- Based on the NASDAQ Composite's movement (IXIC), we can see how certain stocks in certain sectors react differently, in similar trends
- In the case of stocks such as LULU and TSLA , we can see that the Beta value is extremely high, as their corrections and impulse moves are severely exaggerated compared to IXIC
- Amazon's movement also reflects a high beta value, but not as high as that of TSLA and LULU
- COST, on the other hand, seems to have a beta value close to 1, as it follows the movement of IXIC. It's less risky, as the drops are not as severe, but the potential profits are not too high either
- SQQQ , on the other hand, is a 3x leveraged ETF that tracks the Nasdaq 100 index . As such, it has an inverse beta value, and shows huge spikes during times of correction for IXIC
Limitations of Beta
- The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective, but returns aren’t always normally distributed.
- A stock with a very low beta could have smaller price swings, yet it could still be in a long-term downtrend. So from a practical perspective, a low beta stock that's experiencing a downtrend isn’t likely to improve a portfolio’s performance.
- While the Beta value is useful in determining a security's short-term risk, it becomes less meaningful for investors attempt to predict a stock's future movements.
Conclusion
Understanding the concept of Beta is essential in portfolio diversification. A good investor can identify bullish and bearish market trends, and rebalance their portfolio accordingly. A good balance of securities with varying Beta values is imperative for a good balance between risk management and profit maximization.
