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
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!