FFI – Online Executive Education provides everyone with a tool to calculate the beta of all the stocks listed in the United States. But what is the beta again and how can we use it in portfolio management? Let us review and talk about its characteristics.
1 – What is the beta?
The beta is a volatility or sensitivity coefficient that indicates the relationship between fluctuations in a financial security’s value and the market.
- A beta equal to 1 tells us in general that the security behaves like the market: its variations are aligned with the market.
- A beta of less than 1 is characteristic of a less volatile security that mitigates market fluctuations.
- On the contrary, a security with a beta greater than 1 is more volatile than the market as a whole.
We can calculate the beta as the regression of the security’s daily variations against those of the market.
2 – Why is the beta useful?
Knowing intuitively whether one should invest in a volatile stock or not, depending on the level of trust we have in the market’s current health state and predictions.
High beta securities are favored if you feel optimistic. And low beta securities will have the preference if caution is required and you want to play it safe.
3 – What are the parameters determining the beta level?
Beta depends mainly on:
A. Operating Leverage, which is the cost structure. High fixed costs result in a higher beta.
B. Financial Leverage, meaning the liability structure. High debt means high risk for the shareholder (financial risk is added to operational risk), and a higher beta.
C. Cyclicality of the related sector. If the sector is cyclical, the company’s results depend on the economic situation, and the beta is higher.
D. The expected growth of results. High growth means a high beta. Because any change in economic conditions will have a significant effect on the results’ growth and therefore on the profitability of the security.
4 – But before we illustrate the influence of the parameters…
We must note that it is calculated on past data, so the beta will depend on the observation period, the data’s frequency (daily, weekly), and also the benchmark (should Apple’s beta be calculated against the NYSE or the NASDAQ for example?).
And over what period should we calculate it?
Being an ex-post calculated value, it is necessary to decide the period of observation. It can neither be too short nor too long. If too short, the calculation does not reflect the latest movements of the security. When too long, the beta includes data that could be outdated (the company has changed in nature, the conditions are different, etc …).
We usually make all our calculations over a three years period, unless otherwise stated.
So let’s run through an example. Here is the beta calculated based on one to five years for several well-known securities: Apple, Walmart, and ArcelorMittal.
For Apple and Walmart, the issue of the observation period seems of little importance. With ArcelorMittal, on the other hand, the beta calculated over one year is much higher than the other values and shows a growing volatility of the security.
Let’s calculate ArcelorMittal’s “beta three years” for the past five years.
We see a decrease from 2013 to 2015 with a low beta at that time. Then a change into a higher beta in 2017, which tells us the volatility was increasing over time.
Stay tuned for Part 2 of everything you need to know about the beta in a security. Until then, here are a few useful links for you to experiment and learn about this useful metric.
To learn more about the beta, CAPM, cost of capital, and risk with one of our certificate programs: