Here’s how beta works, the coefficient that represents the systematic risk of a security and helps evaluate the soundness of an investment.
Knowing how to calculate the return of a stock is an essential element when talking about stocks to invest in. Before evaluating the convenience of trading a stock, it will be important to understand what our potential risk/return ratio will be.
When talking about risk of an investment, however, we cannot ignore the beta, that is, the quantity that measures the expected variation in the return of a certain stock for each variation of a single percentage point of the reference market. But, before finding out how it works and how it is calculated, let’s go in order.
How to evaluate the risk of a stock?
The risk of a stock can be identified with the variability of its return. In essence, a stock is riskier the greater the variability of its return around the expected value. Securities that offer very high returns are also those with a higher level of risk.
For example: securities issued by larger companies, operating in relatively mature and stable sectors, are characterized by lower average or expected returns, but also by a lower degree of risk compared to securities issued by companies operating in innovative sectors. The latter are in fact characterized by high growth potential but at the same time by higher risk.
The risk profile of a security can be calculated using two main indicators:
- volatility: represents the overall variability of the return of a security and is generally estimated on the basis of the standard deviation of the variations in the price of the individual security. A security with a price that undergoes more pronounced fluctuations is considered riskier than a security with a more contained price variability.
- beta: measures the sensitivity of the individual security to variations in its reference index.
In essence, therefore, the variability of the yield of a security can be divided into two components:
- a non-systematic or diversifiable component, which depends on the evolution of the specific characteristics of the issuer of that security. This part of the risk can be eliminated with an appropriate policy of investment diversification;
- a systematic and non-diversifiable component, which depends on the fact that the yield of the security is inevitably linked to that of the entire stock market. Diversification of investments cannot protect them from the systematic part. The sensitivity to variations of the stock market is measured by the beta of each security.
What is the financial beta coefficient (and how it impacts risk)
The beta therefore represents a measure of the degree of systematic risk of a security. Based on the values that beta can assume, three situations emerge.
- Beta > 1: aggressive stock that tends to amplify the fluctuations of the reference market. It is therefore a stock from which investors expect a high return.
- Beta < 1: defensive stock that is little affected by market fluctuations and from which investors expect a more limited return.
- Beta = 1: neutral stock reacts to market fluctuations in a proportional way. The variations of the stock replicate exactly those of the index.
In essence, with this value (belonging to the scope of the Capital Asset Pricing Model) we have a quantitative evaluation of each stock. Below is a table illustrating the relationship between beta, specific risk and systematic risk.
| Title | Volatility | Beta | Overall risk | Systematic risk | Specific risk |
|---|---|---|---|---|---|
| A | 5% | 1.5 | low | high | low |
| B | 10% | 1.0 | medium | medium | medium |
| C | 15% | 0.5 | high | low | high |
For example, consider a stock like Eni, which - let’s assume - has a one-year beta of 0.87. Therefore, as a rule, with a 1% movement in the FTSE Mib, the six-legged dog stock would tend to have a positive variation of 0.87%. On the contrary, in the event of a 1% drop in the index, Eni should mark -0.87%.
Beta coefficient of a portfolio
When we move from a single stock to a portfolio of multiple stocks, we can calculate the beta of the portfolio by means of a weighted average of the various coefficients.
Suppose we have a portfolio divided into three stocks A, B, C with the characteristics illustrated in the following table.
| Stock | A | B | C | total |
| value | 25 | 15 | 10 | 50 |
| weight in % | 50 | 30 | 20 | 100 |
| beta | 1.2 | 1 | 0.8 | - |
The beta of the entire portfolio can be calculated as a weighted average of the beta coefficients of the stocks that compose it.
Original article published on Money.it Italy. Original title: Cos’è il coefficiente beta di un titolo e come funziona
