How to use Beta to assess your Portfolio Risk

Among all the tools that an investor has in their toolbox to gauge a security or a portfolio volatility, Beta is one of the easiest to calculate and use.?

Beta is one of the parameters needed whenever the practitioner wants to calculate the "Cost of Equity" for a particular company. The Cost of Equity is used, for instance, in the Dividend Discount Model as the discount factor to calculate the fair value of a security.

An investor can also use Beta to gauge the volatility of their portfolio vs. a benchmark. I find the picture below from Investopedia very useful in illustrating the concept of Beta.

Beta measures the volatility of security vs. the market as a whole. Usually, practitioners use the S&P 500 as a good proxy for "The Market." The practitioner must choose a market proxy based on the security they want to analyze. This index is the one an investor should choose for a US Stock that is included in the S&P 500. If the security is part of the Russel 2000 of small caps, the investor will choose the Russel 2000 as the index proxy.

Assets with a Beta above one tend to be more volatile than the benchmark, while investments with a Beta below 1 are less sensitive to big price chances in the same index.

Usually, technology stocks have Betas well above one, while miners and utilities have betas below one. When the investor thinks there may be a recession around the corner, reducing the Beta of her portfolio is prudent to reduce the chance of a significant drawdown of her investments. At the start of a new economic cycle, increasing the Beta of the portfolio may be warranted to take advantage of a general appreciation of assets during the early stages of recovery.

Beta is calculated as follows.

Disadvantages of Beta

There are limitations that the practitioner has to take into consideration when using Beta for investment purposes.

Beta is a valuable indicator used to assess the risk of a security and for assessing volatility in calculating the Cost of Equity of an asset.

However, Beta is a backward-looking indicator. It is calculated using a time series of returns, making it less useful for investors who want to predict a stock's future valuation.

Beta is also less helpful for investors with a long-term horizon since a stock's volatility can change significantly yearly, depending on the company's growth stage and other factors.?

Furthermore, the Beta measure on a particular stock tends to jump around over time, which makes it unreliable as a stable measure. I plot here below the rolling Beta of Apple vs. the S&P 500. As you can see from the chart, the Beta of Apple fluctuated considerably over the past ten years.

Conclusion:

Despite the drawbacks listed above, Beta is a valuable tool for an investor to assess if their portfolio is more or less risky than the market.?

At the peak of a cycle, where we are now, it is prudent to have a portfolio Beta below one to protect portfolios from large drawdowns.