How to measure risks with Beta (β)? (Part 3 of 4)

The Beta of an asset or portfolio can serve as a statistic for making investment decisions based on risk.

If the factors that have determined the fluctuations in the past are reproduced in the future (systematic risks), under normal market conditions, Beta is a statistic that can help us to estimate the relative risk of an asset in relation to an index of market reference (benchmark). 

Risk estimation and management

Beta only informs us of the sensitivity of the systematic risks of an asset or portfolio in relation to how the market reacts to these same risks. Therefore, it only serves to estimate the level of sensitivity to these risks relative to the market.

If we only have Beta

If we only have the information provided by Beta, we can only determine whether an asset or portfolio has more or less risk than a particular market represented by an index. In this sense it only helps us to sort the assets or portfolio of assets according to a greater or lesser sensitivity (risk).

Let’s take a few examples for the case of an Mutual Fund whose benchmark is the S&P 500:

  • A Beta of 1 means that the Mutual Fund has been as volatile as the S&P 500 index. If the index goes up or down by 10%, the Mutual Fund would also go up or down by 10%.
  • If the Beta of the Mutual Fund were equal to 1.2, the Mutual Fund would fluctuate 20% (1.20 – 1 = 0.20) more than the S&P 500 index and in the same direction as the S&P 500.
  • If the Beta of the Mutual Fund were equal to 0.7, the Mutual Fund would fluctuate 30% (1 – 0.70 = 0.30) less than the S&P 500 index and in the same direction as the S&P 500.
  • If the Beta of the Mutual Fund were equal to – 1.50 the Mutual Fund would fluctuate 50% (1.5 – 1 = 0.50) more than the S&P 500 index but in the opposite direction (negative sign of the Beta) to the S&P 500 index.
  • If the Beta of the Mutual Fund were equal to – 0.2 the Mutual Fund would fluctuate 80% (1 – 0.20 = 80) less than the S&P 500 index but in the opposite direction (negative sign of the Beta) to the S&P 500 index.

If we also have the volatility of the benchmark index

If, in addition to the Beta, we have information on the volatility of the market index in which that asset is included or serves as a reference to that portfolio of assets, we can estimate the total risk of an asset or portfolio.

This exercise can be performed as long as the asset or portfolio is adequately diversified (almost eliminating the unique risks of the asset or assets in the portfolio). Otherwise, we are underestimating the total risk, because we have not taken account of the unique risks. 

Let’s take a few examples, assuming that the volatility of a given index was 20%:

  • If the Beta of the Mutual Fund is 1.50, we can estimate that the volatility of the Mutual Fund is 30% (20% x 1.5).
  • If the Beta of the Mutual Fund is 0.8, we can estimate that the expected volatility of the Mutual Fund is 16% (20% x 0.8).
  • If the Beta of the Mutual Fund is -0.4, we can estimate that the expected volatility of the Mutual Fund is 8% (20% x 0.4).

For advanced investors:

In the case of an advanced investor, the systematic risks to a particular asset or to the entire portfolio can be reduced at a given time or structurally.

Systematic risk reduction can be achieved in various ways through the appropriate use of financial derivatives (e.g. options and futures), taking contrarian positions in the market.

Collection of articles about Beta Coefficient (β):

  1. What is the Beta coefficient in finance?
  2. How is Beta interpreted?
  3. How to measure risks with Beta? (current post)
  4. How to estimate returns with Beta?
José Luís Álvarez – CEO HollyMontt

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