Hey everyone.
This is Kirk, here again at optionalpha.com.
And in this video, we’re going to be talking about portfolio Beta.
What is Beta?
Beta is simply market risk.
That’s really what Beta is going to measure.
It’s a measure of a stock’s volatility in relation to the overall market.
If we are measuring a stock’s volatility in relation to the market, we have to know
what the market is.
By definition, the market has a Beta of one and generally, we accept that the S&P 500
index is the best and most efficient portfolio and that's the index that we’re going to
relate as a Beta of one.
Individual stocks are ranked according to how much they deviate from how the S&P 500
trades.
How do we use it?
As you can imagine, the concept of risk is pretty hard to pin down and factor in a stock
analysis and valuation.
What’s risky to one person may not risk be risky to another person.
We use Beta as a central focal point and the statistical rating to judge the level of risk
a stock has compared to the overall market.
We use the market as our benchmark or backdrop and then we overlay that stock’s Beta to
see how it relates to the most efficient portfolio out there.
Remember that the S&P 500 index is the efficient frontier.
It’s the most efficient combination of 500 securities that you can have.
Therefore, Beta offers a clear quantifiable measure which makes it easy for us to work
as stock traders and portfolio managers.
On just a side note, I’ll be covering this on other videos in the coming weeks and months.
Beta is definitely a key component for the capital asset pricing model which is called
the CAPM and it’s used to calculate the cost of equity.
Generally, the higher the Beta, the more expensive an equity becomes because there's more risk
and that’s just plain commonsense I guess.
The higher the risk, the more expensive it's going to be for the cost of equity.
When we talk about high or positive Beta, basically what we mean is that a Beta of one
shows that a stock is as volatile as the market and will more or less tend to follow the market.
A Beta of one means it’s actually equal to the market, so it’ll follow the market
pretty well.
For the S&P 500 index, a Beta of one stock would be the SPY which is its correlating
ETF.
It’s going to follow the market pretty much in lockstep.
If the market climbs by 5%, then the price of the stock is also going to climb by 5%.
This is a Beta of one.
Betas greater than one make a stock riskier than the market and more volatile.
For example: If a stock has a Beta of two, then the stock is going to climb 10% when
the market climbs 5% possibly.
That shows you how the differences in Beta work.
When we talk about low or negative Beta, we’re talking about stocks with negative Beta that
are theoretically bound to move in the opposite direction.
A Beta of negative one versus one means that if the market climbs by 5%, the price of the
underlying stock is going to fall by 5%.
Betas less than one make the stock less riskier than the market and thus less volatile.
Actually, that should be more risky than the market and thus more volatile.
If we look at a histogram here of monthly returns on the S&P 500, you can see that a
Beta of one is going to be in this red and you can see that it’s generally a nice even
bell curve distribution.
Most of the returns on a monthly basis are between 1% to 3%, very little monthly returns
in the +10 or –11 area.
A lower Beta stock may have returns that are more distributed.
It's lower Beta, it’s less volatile, so it’s not going to have these big high spikes.
These averages around 1, 2 may have a general average in the 4, 5 type of range.
This is how we use Beta as a benchmark to understand how a volatile stock is compared
to the overall market.
When you hear a lot of people talking about Beta, they’re usually talking about how
they can adjust Beta, how they can compensate for Beta in their portfolio.
Generally, people like to create strategies and add stocks that make up a Beta rough to
or equally around one, so that they mimic the S&P 500 without having to go out and buy
all 500 securities.
I hope you guys have really enjoyed this video as always and thanks for watching.
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