On a construction site, you’ll hear the phrase “measure twice, cut once.” When constructing an investment portfolio, you may need to measure, re-measure, and re-re-measure potential risk before you act.
Beta measures the volatility of an asset or a whole portfolio relative to the broader market. You may also hear it called beta coefficient. Same thing. And the nerd in all of us might like to know that beta is calculated using regression analysis.
Beta isn’t new, but fast-moving markets make it an increasingly common tool used by risk-minded investors. It routinely pops up in investing vernacular. It also has its limitations.
Here are some hints on how to mind your beta.
Beta is often used to compare how much an individual stock moves relative to the rest of the market. A stock with a beta of 1.50 has historically moved plus or minus $1.50 for every similar $1.00 move in a benchmark, such as the S&P 500. Likewise, a stock with a beta of 0.50 has historically moved $0.50 for every $1.00 move in the benchmark. So, a risk-averse investor is likely to choose the stock with a lower beta of 0.50, right? The simple answer is yes … for now.
Stock beta changes over time, especially when market trends change. Consider the case of Exxon Mobil (XOM), which is often thought of as a low-beta stock. Over a 10-year period, the stock’s beta fluctuated back and forth between 0.41 and 1.05. It was near 0.867 in early 2015 (figure 1). Based on that measure, this stock cooks at low and slow, characteristics that may satisfy some investors who’d like to potentially skip a lot of drama (forgoing potentially market-beating upside, too). In this case, they probably like the dividend potential and hope for a steady uptrend in price. XOM is just an example—no recommendation here.
In general, as a stock’s beta falls, its relative volatility falls. As a stock’s beta rises, its relative volatility rises. All stock betas can, and do, change over time, so a passive investor may accidentally end up with a much riskier portfolio than desired after a while.
It’s important to be proactive in measuring your stocks’ betas. If a stock no longer meets your expectations, you may need to make an adjustment.
Measuring beta can be most useful when weighting an entire portfolio of different assets. Beta-weighting a portfolio is essentially taking a portfolio of apples and oranges—and turning them all into bananas. That way, you can estimate how much your whole “banana” portfolio is likely to move relative to your benchmark.
Gauging portfolio beta can be valuable when you’re anticipating market instability. Rather than selling your stocks to reduce risk, you might hedge only the portfolio’s excess risk temporarily, possibly with options strategies.
It’s worth pointing out that there are many other methods of measuring risk, each with its own benefits and risks. Consider this your introduction and watch for upcoming coverage, where we’ll dig into the math and more. The bottom line is to be mindful of the changing nature of risk. Measuring it accurately, and actively pursuing strategies to reduce it, can potentially improve your investment results.
The beta weighting feature of the thinkorswim® platform's Monitor tab is a favorite feature of many experienced traders for use in assessing systemic or market risk.