A measure is needed of this unavoidable systematic or non diversification risk. Based on modern portfolio theory, the beta has emerged as such as measure Beta’s usefulness as a measure of risk is briefly discussed here.
Beta is a relative measure of risk -the risk of an in individual stock in relation to the overall market. As measured by the volatility of its return. By statistically relating the returns for a security to the returns for the stock market as a whole. It is possible to determine how the security’s return move in relation to the market’s return move more(less) volatile than market.
For example a security whose returns rise or fall on average 15% when the market return rise or falls 10% is said to be volatile security.
Beta is the slope of the regression line relating a security’s returns to those of the market. If the slope of this relationship for a particular security is a 45 degree angle for security B beta is 100.
This means that for every 1% change in the market’s return,on average this security’s returns change 1%. If the line is higher. Beta is higher meaning that the volatility (market risk) is greater.
For example security A’s beta of 15 indicate that, on average security return are 1.5 times as volatile as market return both up and down.
If line is less steep than the 45 degree line. Beta is less than 1.0 this indicate that, on average a stock’s return have less volatility than the market as a whole.
For example, security’s beta of 0.6 indicates that stock returns move up or down generally only 60% as much as the market as whole.
In summary, the aggregate market has a beta of 1.0. More volatile(risky) stock have larger bets and lets volatile(risky) stocks have bets smaller than 1.0. As a relative measure of risk, beta is very convenient.
If an investor is considering a particular stock and is if informed that its beta is 1.9. This investor is considering a particular stock and is informed that its beta is 1.9.
This investor can recognize 7immediately that the stock is very risky. In relation to the average stock because the average beta for stock is 1.0.
Many brokerage house and investment advisory services report beta as part of the total information given for individual stock
Beta (estimating systematic risk)
Betas are estimated from historical data, regressing for the individual security against for the some market index. As a result, the usefulness of beta will depend among other factors the validity of the regression equation. Regression of how good the fit is, Beta is an estimate subject to errors.
It is important note that most calculated betas are ex post betas what is actually needed in investment decision is a beta measuring expected volatility.
The common practice of many investor is simply to calculate the beta for a security and assume it, will remain constant in the future, a risky assumption in the case of individual securities similar to standard deviations.
Portfolio betas after are quite stable across time whereas individual security betas often are notoriously unstable. However this is not an unfavorable outcome for investor because the basic premise of portfolio theory is the necessity of holding a portfolio of securities rather than only one or a few securities.
One method of estimating beta is to employ the historical regression estimate but subjectively modify it for expected as known change. Infact, it is logical to begin the estimation of beta using the best estimate of the historical beta.
Substantive evidence has been presented that betas tend to move toward too over time. Betas substantially larger (smaller) then too should tend to be followed by betas that are lower(higher) and closer to 1.0 than the estimate based solely a historical data would suggest.
Several models have been advocated for advertising beta for this tendency to “regrets forward the mean”as result ,it is not unusual to find “adjusted” betas rather than historical betas.
Investor who obtain beta information from such sources are actually using estimated betas.