You may be familiar with the term beta as it’s used in valuing investments. At the very least, if you’re at all comfortable with the Internet (and I assume you are, as you’re reading this blog) you can look it up and find out that it’s a measure of systematic risk. Great! That’s like my husband telling me that bike part over there is a derailleur. Now I know what it is, but I have no idea what it does or how it works with the rest of the bike (though I do know how to spell it, which is no small accomplishment). You may have even been at a party talking investments with someone (whose returns are “fabulous”) when they start tossing out terms like beta. You find yourself nodding along, silently wishing you could clock the guy with your derailleur.
So, what is beta? Well, it’s the Greek letter “b”, which you may remember from college. Not because you took Greek in college, but because your school had a “Greek system” (which is how institutes of higher learning keep you from graduating on time and therefore make more money). As I mentioned earlier, in the context of valuing investments, beta measures systematic risk. Unsystematic risk refers to risk that you can diversify away – industry risk, for example. If you had all your money invested in bank stocks last year, please accept my condolences and go fix yourself a nice, strong drink. If, however, you had a diversified portfolio of financials, consumer goods and services, healthcare, energy, industrials, etc., the returns in sectors such as healthcare and consumer goods would have mitigated (to some degree) the losses in the financial sector. The other type of risk is systematic, or market risk, which cannot be diversified away. Recessions (as we are painfully aware) affect the entire market regardless of business type, industry, and country, and even a properly diversified portfolio cannot escape all risk.
Beta is a number that measures market risk for a particular security. As a baseline, the market has a beta of 1. If a security has a beta of 1, its price is expected to move with the market. If it is less than 1, the price is expected to move less than the market. If it is greater than 1, the price is expected to move more than the market (for example, a beta of 2 indicates a security should move about twice as much as the market).
So now you know what it is and what it measures. The insatiably curious may also want to know how these numbers are derived. For all two of you out there, I will try to make the explanation as short and sweet as possible. Basically, it’s calculated using something called linear regression, which is nothing more than trying to make a straight line out of a bunch of data points that look like buckshot. If you regress the returns of a security against the returns of the overall market, you will get an equation for a line that represents the “best-fit” line through the data points. Beta is the coefficient in the equation that makes it all work.
I hope that was illuminating, and that you haven’t fallen asleep on your keyboard. If you have any questions involving derailleurs, please contact my husband.
Research and Trading Associate