Beta and market risk

In simple terms

When the whole market falls, most shares fall with it, but not by the same amount. Beta measures how much a share's returns have tended to move with the market's returns in the past.

• Beta of 1: the share has tended to move in line with the market.
• Beta above 1: it has tended to move more, rising more in rallies and falling more in declines.
• Beta below 1: it has tended to move less.
• Beta near 0: its moves have been largely unrelated to the market's.

What beta measures, and what it does not

The diversification lesson separated two risks: company-specific risk, which diversification reduces, and market risk, which it cannot. Beta measures a share's exposure to market risk only.

That is why beta is used in the cost of equity lesson's CAPM: the theory says investors are rewarded only for risk they cannot diversify away. But for an investor holding a few shares, company-specific risk is very real, and beta does not see it.

How beta is estimated

Beta is calculated from past returns: the share's returns and the market index's returns over the same periods, often weekly or monthly over several years. Statistically, it is the covariance of the share's returns with the market's, divided by the variance of the market's returns. In plain terms, it is the slope of the line that best fits the share's returns against the market's.

Portfolio beta

A portfolio's beta is the weighted average of its holdings' betas.

If the market fell 20%, this portfolio's beta suggests a fall of about 22%, before any company-specific surprises.

Why beta is unstable

• Period and method: daily, weekly and monthly data give different betas; so do different time spans.
• Business change: a company that takes on debt or changes its business can see its beta change.
• Crises: in severe falls, correlations rise and many shares fall together regardless of their usual beta.
• Thin trading: shares that trade rarely can show artificially low betas, because their prices do not update with the market.

Treat any beta as an approximate, backward-looking estimate.

Low beta is not low risk

A share with a beta of 0.5 has tended to move less than the market. That says nothing about:

• the risk of fraud, a failed product or bankruptcy;
• heavy debt that could sink the company in a downturn;
• the price paid being too high.

A share can have a low beta and still lose most of its value for reasons of its own. Beta is one dimension of risk, not risk itself. The volatility and drawdowns lesson looks at other measures.

Why it matters

Beta is quoted widely on financial websites and used in valuation and portfolio construction. Understanding what it captures, market risk, and what it leaves out, company-specific risk and changing conditions, keeps you from treating a low beta as a safety certificate.

Limitations

Beta depends on the index chosen as "the market", the data frequency and the period. It describes the past and can change sharply. It assumes a straight-line relationship with the market that may not hold, especially in extreme moves.

Common mistakes

• Treating a low-beta share as safe.
• Treating beta as fixed.
• Ignoring company-specific risk in a concentrated portfolio.
• Comparing betas calculated in different ways.

Try it yourself

1. Look up the beta of three shares on two different financial websites and note any differences.
2. Calculate a made-up portfolio's beta from weights and those betas.
3. Estimate what that beta suggests for a 15% market fall.
4. Write down one company-specific risk for each share that beta would not capture.