What is a stocks Beta? Assess the risk of your portfolio with this simple method.

When reading stock quotes, among the many ratios available, we often notice a Beta numeric value associated with a stock. Simply put, beta measures the stocks volatility in relation to the market. With this simple indicator an investor can assess the risk associated with a particular stock.

What does a Beta value of 1 mean?

A Beta value 1 simply means that the stock price moves along with the market. For example, if the S&P 500 moved by 1%, one would expect the stock for a company X to move by 1% as well.

Generally, a low beta value(less than 1), indicates that the stock price is not as volatile as the market, and is considered a less risky investment. Conversely, a high beta value(greater than 1), would be considered high risk and high return, due to its volatility.

The formula to compute this is below

Beta = Covariance(Stock Returns, Benchmark Returns) ÷ Variance(Benchmark Returns)

Therefore, if you wished to compute the Beta value for Netflix, listed on the index NASDAQ

Beta = Cov (NFLX, NASDAQ) ÷ Variance(NASDAQ)

Using this ratio, an investor can quickly identify his risk reward ratio allowing him to make the choice between low risk and high risk stocks. While beta is a useful risk assessment tool, it must be noted that it does so only for the short-term, where volatility is useful. For value investors and long term risk assessments, several fundamental and economic factors must be taken into account.

 Portfolio Beta vs Individual Stock Beta

A more useful approach to using beta for risk analysis, would be to compute your entire portfolios beta value as opposed to using a single stock beta. Let us take a simple portfolio of 3 stocks : A, B and C

portfolio_beta
Computation of Portfolio Beta

The above image snapshot shows that the total portfolio value is of $22,000 where companies B and C have a lower beta value but company A falls under the high risk category. Our portfolios will often comprise of several stocks from various sectors, and it is better to compute the entire portfolios beta in such a case.

In order to do this we must compute a weighted average for all holdings. Therefore the weighted beta value will be:

Weighted Beta = Value of individual holding x Beta of individual stock

Weighted Beta (A) = 10,000 x 1.6 = 16000

Similarly we can compute the weighted beta values for B and C and add the total value for the entire portfolio.

Now to compute the portfolio beta value simply do the following:

Portfolio Beta = Sum of all weighted betas ÷ Total portfolio value

Beta = 26,300 ÷ 22,000 = 1.20

As you can see that our entire portfolio has a beta value greater than 1, showing higher volatility and risk as compared to the market. After performing this assessment, an investor can manage his portfolio in the following ways:

  • Add more low risk stocks to the portfolio. Example, purchase more of company B
  • Reduce holdings for high risk stocks. Example, reduce holding for company A
  • Hedge against the entire portfolio

While the first 2 options are easy to understand, hedging can be a tricky subject requiring deeper understanding. I intend to cover this topic in my posts to follow and provide an insight into the use of futures for the purpose of hedging.

I hope this simple statistic and methodology can be used to your advantage and provide you the ability to make the right investing decisions.

Be Frugal, Be Smart, Be Rich!

 

Related Articles:

Start investing with Mutual Funds – Your guide to Diversification

Stock Market Investing – Understanding Indices & Ratios

 

2 thoughts on “What is a stocks Beta? Assess the risk of your portfolio with this simple method.

  1. Pingback: Manage your portfolio risk with Hedging – The Frugal Investor

  2. Pingback: Manage your portfolio risk with Hedging – Seeking My Utopia

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