Beta

Back to the classroom. In the past two weeks I have written about how to measure risk and return. We learned that we use standard deviation to measure the risk of a security. There are several methods to measure return, including the simple mean, the time-weighted return (also known as geometric return), and the money-weighted return.

So, now the question is, how do we combine securities in a portfolio? Can we simply add securities until we reach some reasonable number? Maybe 30 or 40?

Actually, what we really need to know is how securities act in the marketplace. How do they perform relative the market itself? We might consider the Standard & Poor’s 500 index as a proxy for the market.

We can readily find data for the return of the S&P 500 index. What about the risk of the market? The Capital Asset Pricing Model describes risk with the term Beta. Beta is a measure of volatility of a security. The market itself is assigned a beta of 1. The beta for any security can be calculated through regression analysis. Beta tells us how much the price of a given security will move relative to the market.

If a security has a beta of 1.0, its price movements will mirror the market. A security with a beta greater than 1.0 will be more volatile or risky than the market. A security with a beta less than 1.0 will be less risky than the market. If a security has a beta of 1.5, it will be 50% more risky than the market. A security with a bet of 0.75 will be 25% less risky than the market. What about a beta of zero? This means that there is no statistical relationship between the security and the market. A negative beta indicates that the security acts in opposition to the market. If the market return were up 10%, a security with a beta of -1.0 would theoretically be down by 10%.

So, does that give us enough information to start building our portfolio? No. Come back next week for another critical piece of this puzzle.