The Beta coefficient is a statistic that helps us understand market risk from a complementary perspective to volatility and other metrics that are used for this purpose.
Market risk is the risk associated with the fluctuations that a financial asset has due to it trading on financial markets.
Unique risks and systematic risks
To be able to understand the Beta coefficient, we need to first understand how diversification affects the market risk of a financial asset, in particular company shares.
Market risk is divided into two main types of risk:
1. Unique risks, idiosyncratic, unsystematic or diversifiable risks.
The unique risks are the risks we have when investing in a specific financial asset and which are related to the particular characteristics of that asset.
When we talk about shares of a company, these are the risks that affect only that specific company and need not affect the overall nature of the other companies in the market. Examples include risks related to the quality of the management team, labour disputes or the location of the company.
The characteristic that interests us about this type of risk is that it is easy to reduce through diversification. Empirically, with adequate diversification from 25-30 assets we are able to drastically reduce the single risks in a portfolio. This is why diversification is one of the fundamental principles for an investor to follow.
It is very common to find the portfolios of individual investors concentrated in only a few assets without an overall diversification strategy. These aggregates of financial assets have been built over time solely on the basis of expected returns at different times and involve taking on a higher level of risk than a properly diversified portfolio.
As we will see below, taking on single risks for an undiversified portfolio will not be rewarded by the market through returns.
2. Systematic risks.
Systematic risks are the risks that affect companies because they are in the market.
Systematic risks affect all companies, but not all companies in the same way. The impact of each systematic risk will depend on the exposure of each company to each of these risks.
Examples include market interest rates, the price of raw materials, economic recessions, or changes in the government’s trade agreements with other countries.
The important feature of systematic risks is that they cannot be reduced by simple diversification (by adding more assets to a portfolio).
However, at the overall portfolio level, there are tools that can reduce market risk from systematic risks and, therefore, the exposure of the portfolio as a whole to these types of risk. These tools are optimisation algorithms. These algorithms analyse the different behaviour of different market assets in relation to these risks.
For this reason, adding assets to a portfolio by intuitively trying to diversify, without using the necessary metrics and algorithms, is a strategy that leads to an overall lower risk-adjusted return profile than that of an optimised portfolio.
As with unique risks, the market (via returns) will not reward taking on more systematic risk for having a non-optimised portfolio.
What is Beta?
The Beta coefficient is a statistic whose objective is to measure the level of exposure of a financial asset or a group of them (for example, an Mutual Fund) to systematic risks only.
While volatility shows how the market reacts to all the risks of a given financial asset, Beta only shows how the market reacts to the degree of exposure of a financial asset to systematic risks.
Unlike volatility, which is a statistic whose objective is to measure the total fluctuations of a financial asset or a group of them in the market, the objective of the Beta is to measure the fluctuations of that asset or portfolio in relation to the market itself. Beta measures how an asset fluctuates relative to the market.
What is the point of calculating the Beta?
The calculation of the Beta is motivated by the need to know the fluctuations of an asset as a result of its systematic risks.
As previously explained, single or non-systemic risks are easily eliminated with adequate diversification. For this reason, it is considered that there should be no returns reward via returns for taking risks that the investor should easily eliminate. In financial theory, there is no returns reward for taking unique risks.
The returns obtained, and therefore also expected, are explained by taking on those risks that cannot be eliminated by diversification (systematic risks) and are what we try to measure through the Beta.
Collection of articles about Beta Coefficient (β):
- What is the Beta coefficient in finance? (current post)
- How is Beta interpreted?
- How to measure risks with Beta?
- How to estimate returns with Beta?
