A measure of a security's sensitivity to movements in the overall market
Published March 21, 2020
Updated May 15, 2023
What is the Beta Coefficient?
The Beta coefficient is a measure of sensitivity or correlation of a security or an investment portfolio to movements in the overall market. We can derive a statistical measure of risk by comparing the returns of an individual security/portfolio to the returns of the overall market and identify the proportion of risk that can be attributed to the market.
Systematic vs Unsystematic Risk
We can think about unsystematic risk as “stock-specific” risk and systematic risk as “general-market” risk. If we hold only one stock in a portfolio, the return of that stock may vary wildly compared to the average gain or loss of the overall market as reflected by a major stock index such as the S&P 500. However, as we continue adding more to the portfolio, the portfolio’s returns will gradually start more closely resembling the overall market’s returns. As we diversify our portfolio of stocks, the “stock-specific” unsystematic risk is reduced.
Systematic risk is the underlying risk that affects the entire market. Large changes in macroeconomic variables, such as interest rates, inflation, GDP, or foreign exchange, are changes that impact the broader market and that cannot be avoided through diversification. The Beta coefficient relates “general-market” systematic risk to “stock-specific” unsystematic risk by comparing the rate of change between “general-market” and “stock-specific” returns.
The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (or CAPM) describes individual stock returns as a function of the overall market’s returns.
Each of these variables can be thought of using the slope-intercept framework where Re = y, B = slope, (Rm – Rf) = x, and Rf = y-intercept. Important insights to be gained from this framework are:
- An asset is expected to generate at least the risk-free rate of return.
- If the Beta of an individual stock or portfolio equals 1, then the return of the asset equals the average market return.
- The Beta coefficient represents the slope of the line of best fit for each Re – Rf (y) and Rm – Rf (x) excess return pair.
In the graph above, we plotted excess stock returns over excess market returns to find the line of best fit. However, we observe that this stock has a positive intercept value after accounting for the risk-free rate. This value represents Alpha, or the additional return expected from the stock when the market return is zero.
How to Calculate the BetaCoefficient
To calculate the Beta of a stock or portfolio, divide the covariance of the excess asset returns and excess market returns by the variance of the excess market returns over the risk-free rate of return:
Advantages of Using Beta Coefficient
One of the most popular uses of Beta is to estimate the cost of equity (Re) in valuation models. The CAPM estimates an asset’s Beta based on a single factor, which is the systematic risk of the market. The cost of equity derived by the CAPM reflects a reality in which most investors have diversified portfolios from which unsystematic risk has been successfully diversified away.
In general, the CAPM and Beta provide an easy-to-use calculation method that standardizes a risk measure across many companies with varied capital structures and fundamentals.
Disadvantages of Using Beta Coefficient
The largest drawback of using Beta is that it relies solely on past returns and does not account for new information that may impact returns in the future. Furthermore, as more return data is gathered over time, the measure of Beta changes, and subsequently, so does the cost of equity.
While systematic risk inherent to the market has a meaningful impact in explaining asset returns, it ignores the unsystematic risk factors that are specific to the firm. Eugene Fama and Kenneth French added a size factor and value factor to the CAPM, using firm-specific fundamentals to better describe stock returns. This risk measure is known as the Fama French 3 Factor Model.
Other Resources
Thank you for reading CFI’s guide on Beta Coefficient. To keep learning and advance your career, the following resources will be helpful:
FAQs
in statistical analysis, an estimated regression coefficient that has been recalculated to have a mean of 0 and a standard deviation of 1; use of the beta coefficient allows direct comparisons between independent variables to determine which has the most influence on the dependent variable.
What does β mean in regression? ›
Beta is the average amount by which the dependent variable increases when the independent variable increases one standard deviation and other independent variables are held constant. The ratio of the beta weights is the ratio of the predictive importance of the independent variables.
What does beta coefficient of 0.5 mean? ›
If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: A market return of 10% would mean a 5% gain for the company. Here is a basic guide to beta levels: Negative beta: A beta less than 0, which would indicate an inverse relation to the market, is possible but highly unlikely.
What is beta coefficient of CAPM? ›
CAPM Beta is a theoretical measure of the way how a single stock moves with respect to the market, by taking correlation between the both; market represents the unsystematic risk and beta represents the systematic risk. CAPM Beta When we invest in stock markets, how do we know that stock A is less risky than stock B.
What is beta coefficient for dummies? ›
A beta coefficient is a measure of a security's systematic risk relative to the market. It is calculated using regression analysis and is expressed as a number between -1 and 1. A beta of 1 indicates that the security's price moves with the market.
Do you want a high or low beta coefficient? ›
High-beta stocks may be riskier, but provide the potential for higher returns. If a stock moves less than the overall market's volatility, that stock is a low-beta stock with a measurement of less than 1.0. Low-beta stocks pose less risk, but bring the potential for lower returns.
What does β mean in statistics? ›
The beta level (often simply called beta) is the probability of making a Type II error (accepting the null hypothesis when the null hypothesis is false). It is directly related to power, the probability of rejecting the null hypothesis when the null hypothesis is false. Power plus beta always equals 1.0.
What is the difference between B and β? ›
Interpretation of β is analogous to the interpretation of b, except that β expresses change in standard scores. β's are scale free. Some researchers use the relative magnitude of β to indicate relative importance of the independent variables.
Is beta the same as correlation coefficient? ›
Correlation tells us IF 2 variables move together. Are they directionally related, and how strong this relationship is. Beta tells us HOW MUCH a variable moves when compared to another To understand, take some data sets.
Is a beta of 1.5 high? ›
A beta of 1.5 is considered to be a high beta stock. This is because a beta greater than 1 indicates that the stock is more volatile than the market, and therefore carries a greater level of risk.
A stock with a beta of 1.0 indicates that it moves in tandem with the S&P 500. If a stock's performance has historically been more volatile than the market as a whole, its beta will be higher than 1.0. For example, a stock with a beta of 1.2 is 20% more volatile than the market.
What does a beta of 0.45 mean? ›
Low β – A company with a β that's lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period.
What does a beta less than 1 mean? ›
A beta value below 1.0 means that a security is less volatile than the market, making it a less risky addition to a portfolio. For instance, utility stocks often have low betas because they have a more stable value and move more slowly than market averages.
What does beta coefficient of 0.80 and 1.20 indicate? ›
A fund with a beta of 1.20 is 20% more volatile than the market, while a fund with a beta of 0.80 would be 20% less volatile than the market." "Beta is the measure of a fund's volatility relative to the market.
What is a beta coefficient for a risky stock? ›
Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
What do beta coefficients of 0.5 1.0 and 1.5 mean? ›
Answer and Explanation:
The beta coefficient of 0.5 means the investment portfolio is less volatile as compared to the market. The beta of 1.0 means the volatility of the investment portfolio is similar to the market, and the beta of 1.5 represents the portfolio's return is 1.5 times that of the market return.
Is beta 1 the coefficient? ›
We were talking about the simple regression–a regression model with only one predictor variable. She was stuck on understanding the regression coefficient (beta) and the intercept. In most textbooks, the regression slope coefficient is denoted by β1 and the intercept is denoted by β0.
What is β in statistics? ›
So what is beta? Beta is the probability that we would accept the null hypothesis even if the alternative hypothesis is actually true. In our case, it is the probability that we misidentify a value as being part of distribution A when it is really part of distribution B. A standard power metric is often .
