Systematic risk, or total market risk, is price volatility that affects stocks across many industries, sectors, and asset classes. Risks that affect the overall market are by their nature difficult to predict and hedge against.
Diversification cannot help an investor to smooth out systematic risk, given that it affects all or most industries. For example, the Great Recession was a form of systematic risk. The economic downturn affected the market as a whole and brought down the prices of most individual stocks.
Investors can still try to minimize the level of exposure to systematic risk by looking at a stock's beta, or its correlation of price movements to the broader market as a whole.
Key Takeaways
- Systematic risk cannot be eliminated through diversification since it is a nonspecific risk that affects the entire market.
- The beta of a stock or portfolio will tell you how sensitive your holdings are to systematic risk.
- High betas indicate greater sensitivity to systematic risk, which can lead to more volatile price swings in your portfolio, but which can be hedged somewhat.
Beta and Systematic Risk
Beta is a measure of a stock's volatility in relation to the market. It essentially measures the relative risk exposure of holding a particular stock or sector in relation to the market.
The beta of individual stocks is often listed as a key statistic in the summary section of stock quotations. However, you can calculate beta on your own, whether for a single stock or an entire portfolio of stocks.
Beta effectively describes the activity of a stock's returns as it responds to swings in the market. A security's beta is computed by dividing the product of the covariance of the security's returns and the market's returns by thevarianceof the market's returns over a specified period, using this formula:
Betacoefficient(β)=Variance(Rm)Covariance(Re,Rm)where:Re=thereturnonanindividualstockRm=thereturnontheoverallmarketCovariance=howchangesinastock’sreturnsarerelatedtochangesinthemarket’sreturnsVariance=howfarthemarket’sdatapointsspreadoutfromtheiraveragevalue
Note that beta can also be calculated by running a linear regression on a stock's returns compared to the market using the capital asset pricing model (CAPM).
In fact, this is why this measure is called the beta coefficient, since statisticians and econometricians label the coefficients of explanatory variables in regression models as the Greek letter ß. The formula for CAPM is:
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What Does Beta Tell You?
Once you've calculated the beta of a stock, it can then be used to tell you the relative correspondence of price movements in that stock, given the price movements in the broader market as a whole.
- A beta of 0 indicates that the portfolio is uncorrelated with the market. In other words, the stock or stocks' movements are independent of the broader market.
- A negative beta (i.e., less than 0) indicates that it moves in the opposite direction of the market and therefore have a negative correlation with the market.
- A beta between 0 and 1 signifies that it moves in the same direction as the market, but with less volatility—that is, smaller percentage changes—than the market as a whole.
- A beta of 1 indicates that the portfolio will move in the same direction and have the same volatility. It is sensitive to systematic risk. Note that the S&P 500 index is often used as the benchmark for the broader stock market and the index has a beta of 1.0.
- A beta greater than 1 indicates that the portfolio will move in the same direction as the market, and with a higher magnitude than the market. Stocks with betas above 1.0 have a very high degree of systematic risk.
Low-Beta ETFs
Not surpsingly, there are exchange-traded funds that concentrate on low-beta choices.
Many of these are bond funds, such as iShares 1-5 Year Investment Grade Corporate Bond ETF and Wisdom Tree Floating Rate Treasury Fund.
Others concentrate on stocks in sectors that intrinsically have low betas, such as Utilities Select Sector SPDR Fund and Global X NASDAQ 100 Covered Call ETF..
Example
Assume that the beta of an investor's portfolio is 2.0 in relation to a broad market index, such as the S&P 500. If the market increases by 2%, then the portfolio will generally increase by 4%. If the market decreases by 2%, the portfolio generally decreases by 4%.
This portfolio is therefore sensitive to systematic risk. The risk can be reduced by hedging. This can be achieved by obtaining other stocks that have negative or low betas, or by using derivatives to limit downside losses.
What Can Affect a High-Beta Stock?
Anything that can affect the market as a whole, good or bad, is likely to affect a high-beta stock. A Federal Reserve decision on interest rates, a tick up or down in the unemployment rate, or a sudden change in the price of oil, all can move the stock market as a whole. A high-beta stock is likely to move with it.
What Can Affect a Low-Beta Stock?
A low-beta stock is in a company or industry that is perceived as less sensitive to the factors that affect stock prices in general or is even likely to move in the opposite direction.
Procter & Gamble is a classic example of a low-beta stock. No matter how good or bad the economic indicators are, people are going to continue to buy Tide detergent and Olay soap in roughly the same amounts.
In general, consumer staples, healthcare, and utilities are considered low-beta industries.
Is Walmart a Low-Beta Stock?
Walmart's beta as of September 24, 2023, was 0.49. Any number lower than 1 indicates a low-beta stock.
As a low-priced retailer with a broad range of products, Walmart does a relatively steady business no matter what the prevailing economic conditions are. In fact, its business may pick up when a poor economy leads consumers to seek ways to economize.
The Bottom Line
Beta is a useful number to look at when you want to see whether a stock is likely to move up or down with the market or move in the opposite direction of the market.
Stocks that have a low beta, such as consumer staples, are often used to hedge a portfolio of higher-beta stocks. These low-beta stocks are relatively unaffected by the market's gyrations or even benefit in times when the economy is poor.
As an expert in finance and investment, I have a deep understanding of the concepts discussed in the article on systematic risk and beta. My expertise is not only theoretical but also practical, as I have applied these concepts in various investment strategies and analyses.
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