See Also:
Risk Premium
Hedging Risk
Common Stock
Preferred Stock
Stock Options
Finance Beta Definition
The finance beta definition, or beta coefficient, measures an asset’s sensitivity to movements in the overall stock market. It is a measure of the asset’s volatility in relation to the stock market.
To calculate the beta of an asset, use regression analysis to compare the historic returns of the asset with the historic returns of the stock market. Many often calculate beta using at least five years of historic data.
An asset with a beta of one will fluctuate with the overall stock market. Whereas, an asset with a beta higher than one is more volatile than the stock market. An asset with a beta less than one is less volatile than the stock market. In addition, an asset with a negative beta coefficient moves inversely to the stock market. Beta is used to compute an asset’s expected return in the capital asset pricing model.
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Advantages and Disadvantages of Beta
The advantage of using beta is that it is useful way to gauge an asset’s volatility in relation to the overall stock market. The disadvantage of using beta is that it is based on historical data and may not necessarily be an accurate predictor of future volatility.
Beta of Stocks
The beta of stocks measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.
For example, if a stock has a beta of 1.5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by 15%. (15% = 1.5 x 10%). If a stock has a beta of .5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by only 5%. (5% = .5 x 10%). If a stock has a beta of -1, and the return on the overall stock market rises by 10%, then the return on that stock is expected to decline by 10%. (-10% = -1 x 10%).
Beta of Portfolio
You can also use beta to measure the volatility of an entire portfolio. The beta of a portfolio is simply a weighted average of the assets within the portfolio.
For example, if 50% of the portfolio is comprised of an asset with a beta of .5, and the other 50% of the portfolio is comprised of an asset with a beta of 2, then the portfolio beta would be 1.25. (1.25 = (.5 x .5) + (.5 x 2)).
Similarly, if 25% of the portfolio is comprised of an asset with a beta of .5 and the other 75% of the portfolio is comprised of an asset with a beta of 2, then the beta of the portfolio would be 1.625. (1.625 = (.25 x .5) + (.75 x 2)).
Beta of Market Portfolio
The beta of market portfolio is always one. Because beta measures the sensitivity of an asset to the movements of the overall market portfolio, and the market portfolio obviously moves precisely with itself, its beta is one.
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