Knowledge Centre Archive
Investment Fundamentals: Beta
- Beta measures the sensitivity of a security or a portfolio to the broader market’s fluctuations.
- As a result, investors can use beta to assess how their holdings might respond to rising and falling markets.
- Beta can be a helpful tool for aligning portfolio holdings with an investor’s return objective and risk tolerance.
Beta measures the response of an investment (an individual security or a portfolio) to general market movements. It provides two important pieces of information—direction (positive or negative) and magnitude. When an investment’s beta is positive, it means that the investment tends to experience volatility in the same direction as the market; that is, the market and the investment tend to rise and fall together. If an investment’s beta is negative, it experiences volatility in the opposite direction as the market; when the market rises, the investment falls, and when the market falls, the investment rises. Beta also provides a numerical indication of how sensitive an investment is to market fluctuations. A beta of one indicates that an investment will generally experience the same direction and degree of volatility as the market; a beta of two implies twice the volatility, and a beta of 0.50 implies half the volatility. This relationship still holds when beta is negative, but in the opposite direction. For example, a value of -2.0 indicates that an investment will experience twice the volatility of the market but in the opposite direction.
There are other features of beta that investors should be aware of. First, the market will always have a beta of one, given that beta is calculated against the market’s returns. Second, an investment that exhibits little or no relationship to the market’s fluctuations will have a beta somewhere close to zero. And finally, an investment’s beta may change over time.
The following exhibits compare the simulated (and highly simplified) performance of a hypothetical market to that of higher- and lower-beta investments. In Exhibit 1, the hypothetical investments have betas of 0.5 and 1.5; in Exhibit 2, they have betas of -0.5 and -1.5. As Exhibit 1 shows, an investment with a beta of over 1.0 experiences more volatility (to both the upside and downside) than the overall market, while an investment with beta below 1.0 experiences less. Exhibit 2 depicts the same magnitudes, but with negative signs; investments C and D move in opposite directions to the market as a result—but with different magnitudes, depending on the numerical value of their betas.
Exhibit 1: Simulated Behavior of Positive Betas
Exhibit 2: Simulated Behavior of Negative Betas
Exhibits are based on simulated hypothetical returns. Investment returns for A, B, C and D are (1) indexed to have the same starting prices and (2) assumed to be driven entirely by the market’s returns, which will not hold true with an actual investment.
What Does This Mean for Investors?
Variation among the betas of different investments can be caused by many factors. For example, industries with higher growth expectations and greater uncertainty (biotechnology, for example) tend to exhibit higher betas than more steady businesses (such as utilities). Certain sectors of the market may be more sensitive to external factors (such as interest rates) than the market in general, causing their betas to differ significantly from one. Industry or issuer-specific risks may be perceived as being higher or lower than the general market, resulting in higher or lower betas, respectively. Smaller companies tend to be viewed as riskier and, as a result, their stocks may sport betas higher than one (that is, they may tend to exhibit more volatility than the broader market).
The betas of mutual and exchange-traded funds also vary depending on their investment strategies and underlying holdings. While examining these factors can be interesting and sometimes useful, beta’s value for investors tends to arise from its role in portfolio construction. Like any statistical measure, it should not be used in isolation. But when used properly, it can provide helpful insights into the riskiness of individual securities, the expected impacts of individual securities on a diversified portfolio’s volatility and returns, and the expected riskiness of a portfolio relative to the broader market.
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