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How can you use beta to measure systematic risk in investments?

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If you are an investor, you probably want to know how risky your portfolio is and how it responds to market fluctuations. One way to measure this is by using beta, a statistical indicator that shows the sensitivity of an asset or a portfolio to the movements of a benchmark, such as the S&P 500 index. In this article, you will learn what beta is, how to calculate it, and how to use it to assess the systematic risk and the expected return of your investments.

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Pradeep Gundre

Investments | Director - Top Quartile Fin Serv Pvt Ltd

1 What is beta?

Beta is a measure of how much an asset or a portfolio deviates from the market average in terms of returns. It is calculated by dividing the covariance of the asset or portfolio returns with the market returns by the variance of the market returns. A beta of 1 means that the asset or portfolio moves in sync with the market. A beta greater than 1 means that the asset or portfolio is more volatile and tends to amplify the market movements. A beta less than 1 means that the asset or portfolio is less volatile and tends to dampen the market movements.

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Pradeep Gundre

Investments | Director - Top Quartile Fin Serv Pvt Ltd
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Beta is relative to the movement of the 'whole', the index, the market or any benchmark. Ideally beta is relevant if the entity is a subset of the whole and beta helps to gauge impact on the entity relative to the whole.

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2 How to calculate beta?

To calculate beta, you need to have historical data on the returns of the asset or portfolio and the market for a given period, such as monthly or yearly. You can use a spreadsheet software, such as Excel, to compute the covariance and the variance of the returns. Alternatively, you can use online tools, such as Yahoo Finance, to find the beta of a stock or a mutual fund. For example, if you want to find the beta of Apple (AAPL) stock, you can go to Yahoo Finance, search for AAPL, click on Statistics, and look for the Beta (5Y Monthly) value, which is 1.20 as of June 2021.

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3 How to use beta to measure systematic risk?

Systematic risk is the risk that affects the entire market or a large segment of it, such as inflation, interest rates, or geopolitical events. It is also known as non-diversifiable risk, because it cannot be eliminated by diversifying your portfolio. Beta reflects the exposure of an asset or a portfolio to the systematic risk. The higher the beta, the higher the systematic risk. For example, if the market drops by 10%, an asset or a portfolio with a beta of 1.5 will drop by 15%, while an asset or a portfolio with a beta of 0.5 will drop by 5%.

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4 How to use beta to estimate expected return?

Expected return is the average return that an investor anticipates to earn from an asset or a portfolio over a long period of time. One way to estimate the expected return is by using the capital asset pricing model (CAPM), which states that the expected return of an asset or a portfolio is equal to the risk-free rate plus the product of beta and the market risk premium. The risk-free rate is the return of a safe investment, such as a treasury bill. The market risk premium is the difference between the market return and the risk-free rate. For example, if the risk-free rate is 2%, the market return is 10%, and the beta of an asset or a portfolio is 1.2, the expected return is 11.6% (2% + 1.2 x (10% - 2%)).

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5 How to use beta to adjust your portfolio?

By knowing the beta of your assets or portfolios, you can adjust your portfolio according to your risk tolerance and return objectives. For example, if you are a conservative investor who prefers lower risk and lower return, you can choose assets or portfolios with low beta, such as bonds or defensive stocks. If you are an aggressive investor who seeks higher risk and higher return, you can choose assets or portfolios with high beta, such as growth stocks or emerging markets. You can also mix and match different assets or portfolios with different beta to create a balanced portfolio that suits your preferences and goals.

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Sankar Sharma

Helps Traders and Investors Make their money work in the markets| Provides Trading Education|Independent Technical Analyst | Mentors Traders| Keynote Speaker | Market Strategist | Author
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Amidst rising U.S. fiscal spending, growing national debt, and inflation above 2%, investors must review their portfolios, especially high Beta assets. High Beta assets (>1) increase portfolio risk in volatile markets. Action steps: ? Review individual asset’s beta and portfolio Beta. ? Identify assets with Beta >1. ? Consider reducing high Beta assets to manage risk. In these uncertain times with looming elections and geopolitical risks, being proactive in risk management is crucial. (Disclaimer: This is for awareness, not a buy/sell recommendation.)

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Sankar Sharma

Helps Traders and Investors Make their money work in the markets| Provides Trading Education|Independent Technical Analyst | Mentors Traders| Keynote Speaker | Market Strategist | Author
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Current Economic Landscape and need for Beta check: If you are a portfolio manager or individual investor, it's time to act. The US economic climate is uncertain with fiscal spending at an all-time high, rising national debt, and substantial servicing costs. Despite the Fed's efforts, inflation remains above the 2% target. Geopolitical risks are escalating, we're in a late economic contraction cycle, and upcoming elections in the US and other developed economies, alongside oil price-driven inflation threats, are adding to the strong macroeconomic headwinds. It's crucial to review the high beta exposure of individual assets and your portfolio now. (Disclaimer - this is not a buy or sell recommendation but information to help reduce risk)

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How can you use beta to measure systematic risk in investments?

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1 What is beta?

2 How to calculate beta?

3 How to use beta to measure systematic risk?

4 How to use beta to estimate expected return?

5 How to use beta to adjust your portfolio?

6 Here’s what else to consider

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