Market beta measures the systematic risk of an asset in relation to the over all movement of the market. Systematic risk refers to market risk that affects all investors. It includes macroeconomic conditions, inflation, interest rate changes and economic direction. Systematic risk cannot be diversified.
Systematic vs. Non-Systematic Risk
- Systematic Risk
- Refers to market risk that affects all investors. It includes macroeconomic conditions, inflation, interest rate changes and economic direction. Systematic Risk is not diversifiable.
- Non-Systematic Risk
- Refers to risk that is unique to a business or industry. Adding low correlation funds into your portfolio will allow you to fully diversify your portfolio. Rational investors can eliminate non-systematic risk by diversifying their portfolio. Information on diversification can be found below.
Market Beta and Risk Relationship
The concept of investment risk is hard to pin down and factor into stock analysis and valuation. Therefore, many investment professionals use Beta as a central focal point in judging the level of risk that a particular investment has to the overall market. Beta offers a clear and quantifiable measure which makes it a favorite tool in the investment community. It is also a key component of the Capital Asset Pricing Model.
By definition, a beta is usually equal to 1. Think of 1 being the default beta of a benchmark such as the S&P500. A beta equal to 1 would indicate that a particular security moves in similar manner to the benchmark.
When the beta is lower than 1, this means that the particular stock is a defensive stock and less volatile than its peers. When the beta is greater than 1, this is a risky stock in comparison to the benchmark. We’ve summarized the beta using a graph below.
- If a security has a BETA of 1, then the security’s price will move with the market.
- If a security has a BETA of less than 1, then the security’s price will be less volatile than the market.
- If a security has a BETA of greater than 1, then the security’s price will be more volatile than the market.
Example of Market Beta Calculation
For example, Bell trades on the Toronto Stock Exchange with a market beta of 1.2. This means that the security will be 20% more volatile than the market.
Beta can be a useful metric in determining how volatile a stock’s price may be in relation to the overall market. It’s also a great indicator of risk. One negative aspect of beta is that it relies on past metrics and may not account for current and future improvements that companies engage in.
