Measuring volatility: How to read beta

Beta and Capital Asset Pricing Model (CAPM)

Beta is a measure of volatility or risk in financial markets and is often used with the S&P 500 index to gauge market volatility in the US market. Beta values serve to measure systematic risk, which refers to risk that cannot be eliminated through diversification.

Beta values are an important part of Capital Asset Pricing Model (CAPM), which explains the relationship between systematic risk and expected asset returns. Investors and analysts use CAPM to estimate anticipated returns for individual assets and to calculate the cost of capital for companies, considering the risks associated with those assets.

Within the CAPM, beta values quantify the sensitivity of asset returns to changes in market portfolio returns. In the CAPM equation, the expected return of an asset equals the risk-free rate plus the market risk premium multiplied by the asset's beta. The market risk premium signifies the difference in value between the expected return on the market portfolio and the risk-free rate.

Although CAPM is widely used, the model is subject to limitations and relies on certain assumptions, such as assuming a linear relationship between asset returns and market portfolio returns, assuming homogeneous expectations among investors, and assuming the existence of an efficient market portfolio that encompasses all available information. Therefore, CAPM should be used with caution and supplemented with other valuation methods and risk management techniques to create more informed investment decisions.

Systematic Risk vs. Specific Risk

Systematic risk and specific risk are two types of risks that investors encounter when participating in financial markets. It’s essential for investors to understand the differences between systematic and specific risks and to manage their financial portfolios accordingly.

Systematic risks, also known as market or non-diversifiable risks, are risks that impact the entire market and have a broad impact in financial world. These risks are caused by factors that affect all or most assets in the market, such as changes in interest rates, inflation, or economic growth.

Specific risks are risks that affect individual assets or companies instead of the whole market. These risks are linked to factors that are specific to a particular asset or company, such as changes in management, labour strikes, or product recalls.

Investors can reduce their exposure to specific risks by diversifying their portfolio across different asset classes, industries, and geographic regions. Holding a diversified portfolio mitigates risk, as the performance of one asset can be offset by the performance of others. However, systematic risks cannot be completely avoided through diversification, and investors must accept them as part of the risk-return trade-off when investing in financial markets.

How to interpret beta values

Beta measures the asset’s volatility in relation to the overall market. The market has a beta value of 1.0 and the beta of the assets is compared to that value.

When a beta’s value exceeds 1, it means that the asset is more volatile than the market. For example, a beta of 2 suggests that the asset's returns are expected to move twice as much as the market's returns in either direction. The asset is more responsive to market fluctuations and is likely to exhibit greater price swings compared to the overall market. Investing in assets which have a beta higher than one increases the overall risk level of the portfolio but can also increase the expected return.

Investors may perceive an asset with a beta higher than 2 as a high-risk investment, due to its heightened volatility compared to the market. However, a high-beta asset also presents the potential for greater returns during bullish market conditions.

It’s crucial to note that beta values are merely one measure of risk, and investors should consider other factors such as company fundamentals, industry conditions, and macroeconomic influences when making investment decisions.