Beta: How to Quantify Systematic Risk

Beta can be calculated for individual securities and also entire portfolios. For the first part of this post, we will discuss beta in the context of individual securities.

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Beta is a measure of the volatility of a security compared to a benchmark (usually the S&P 500). In other words, beta quantifies how sensitive a security is to systematic risk. Beta is primarily used in the Capital Asset Pricing Model (CAPM), which is used to quantify the return investors should expect for a given security.

Beta Formula

In the above formula, any index can be selected for the benchmark. Although, the S&P 500 is most commonly used.

Explaining Beta

Let's say a security has a beta of 1.0, then when the market increases by 1%, we can expect the security to also increase by 1%, on average. If beta was 2.0, then the security should increase by 2%, on average. If beta was -1.0, then the security should decline by 1% when the market increases by 1%.

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A security with a beta less than 1 is said to be theoretically less volatile than the market. This means there is theoretically less risk associated with holding that security, but also potentially less reward. The opposite is true for a security with a beta greater than 1.

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Negative beta securities are typically used as hedges. For example, SH is an ETF that tracks the inverse of the S&P 500 index. An investor might hold SH in their portfolio to offset potential declines in the broader market.

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Pitfalls

The primary pitfall of beta is that it is a backward-looking metric. In other words, it is calculated using historical data. And of course, we all know that past performance does not guarantee future results. In this sense, a security's future beta could theoretically diverge significantly from its historical beta. Nevertheless, beta is still widely used in finance as it does give a useful way to ballpark a security's sensitivity to systematic risk.

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Portfolio Beta

Beta can also be calculated for an entire portfolio. You would use the same formula, but substitute the returns of your portfolio for the returns of an individual security. Just like individual securities, portfolios can be more or less volatile than a benchmark.

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So What?

The bottom line is that beta is an important metric to take into consideration when managing your portfolio's volatility.

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If your portfolio beta is too high, you can take steps to reduce it. The simplest way would be to hold more cash. Cash has a beta of 0, therefore, holding more cash will reduce your overall portfolio beta. You can also swap some of your high beta holdings for securities with lower betas. There are also more sophisticated strategies (which we won't get into in this article), such as shorting and options, both of which can be used to offset your overall portfolio beta. But beware that these strategies will introduce other kinds of risk into your portfolio.

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On the other hand, if you find your portfolio beta to be too low, the opposite of the above applies.

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What about alphaAI?

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