Therefore, Beta Coefficient
depends on (1) the variability of the individual
stock return; (2) the variability of the market
return; and (3) the correlation between the return
on the security and the return on the market.
The ratio of the Standard
Deviation measures how variable the stock is in
relation to the variability of the market. The
wider this relationship becomes, the higher risk
is associated with the individual stock relative
to the market. The correlation coefficient in the
formula indicates whether the greater variability
For example, where the Standard
Deviation of the individual stock is .02 and on
the market .10 with a correlation coefficient of
1.0, Beta is 0.2 (.02/.10)(1)=0.2 indicating a
strong positive relationship between the return on
the market and the return on the stock.
When the stock. s return is
less variable than the market as described above,
the stock is less volatile than the market
generally, and the stock has only a small amount
of market risk appropriate for a
However, when the Standard
Deviation is .18 with a Beta of 1.8, the stock is
more volatile than the market and has a large
amount of market risk appropriate for investors
with a more aggressive risk reward perspective.
Generally, as long as there is
a strong relationship between the return on the
stock and the return on the market, i.e., and the
correlation coefficient is not a small number, the
Beta Coefficient has meaning in that if a stock
has a beta of 1, the stock return should move in
lock step with the market index as a whole.
Conversely, a Beta of less than
1 implies that the return on the stock would tend
to fluctuate less than the market as whole.
This is a two edged sword.
Based on a .7 Beta, you could expect the
individual stock to react positively 7/10 of an
increase as a result of a market rise of 10%.
However, if the market declined 10%, you could
expect the individual stock to decrease only 7/10
in relation to the market.
We all know
that the market goes up and
down routinely. Knowing the effect of an individual stock.
s anticipated performance in relationship to
the market in general offers the investor an
opportunity to hedge his or her bets and
construct a portfolio based on his or her
objectives. With a fundamental understanding of
Beta Coefficients, the investor can construct a
portfolio using not only the typical
diversification components of the old economy
versus new economy, growth versus value, domestic
versus international , but characterize the mix
within each sector as it relates historically to
the market overall. This perspective becomes a
very useful tool to identify inherent risk. The
numbers are available from any number of free
services; and the next time you consider buying an
individual stock or mutual fund, check the Beta to
anticipate its performance relative to the market.