Beta is a great trading and portfolio tool when used correctly – yes some people don’t use it correctly I’m afraid. Beta is another one of those crazy greeks that determines the association of a stock or a portfolio to overall markets.
This is something that I haven’t covered in detail before and I apologize for that. I go over this with nearly all of my coaching students but I kept getting questions via email and it seemed that most people really don’t understand how Beta works and how to correctly use it.
--> Hence this awesome video I put together on YouTube.
Systematic & Unsystematic Risk
There are two major types of risk when you invest in the market – systematic and unsystematic risk. I’m sure your probably thinking, “What the hell are you talking about Kirk! Risk is risk right?” Well not exactly and I’ll explain…
Systematic Risk – This is the level of risk that an individual security possesses based on how its correlated with the overall market. These are risk factors that affect the entire market, such as foreign market changes, taxes, global security threats, etc. Exposure to this type of risk is known as Beta.
Non-Systematic Risk – This other level of risk is due to factors completely specific to an industry or a company. Factors that effect a stock’s unsystematic risk could be things like supply shortages, product category, commodity prices, consumer demographic trends, etc.
For example, Apple and Exxon have are both subject to terror threats that effect the entire global markets just like every other company. God forbid something happened tomorrow, every stock would be negatively effected and this type of risk is frankly unavoidable.
However, Apple and Exxon are in completely different industries and a change in oil prices for example will have different effects on each company independently.
The Beta Benchmark?
The most commonly used benchmark in the United States is the S&P 500 index when measuring Beta.
Since Beta is calculated by using regression analysis, the S&P 500 is considered the “Market Portfolio” and is given the number “1”. A positive beta means that the price of the stock will move along the market in lock-step. A negative beta on the other hand implies that prices of the stock will move in the opposite direction.
- Beta of “1” shows that the stock is as volatile as the market and will more or less tend to follow the market higher and lower. If the market climbs by 5%, than the price of your stock should also climb by 5%.
- Beta greater than “1” makes a stock is riskier than the market and more volatile.
- Beta less than “1” makes a stock less riskier than the market and thus less volatile.
- Stocks with negative beta are theoretically bound to move in the opposite direction of the overall market. Beta of “-1” means that if the market climbs by 5%, the price of the stock will fall by 5% and vice versa.
Keep in mind that Beta is the tendency of the stock as it relates to the overall market (usually using the last 5 years of data). So this isn’t a sure thing when trading – what is right? It just gives you a general idea of what kind of risk you are taking on when building a new portfolio.