Complete Guide To Corporate Finance

Return, Risk And The Security Market Line - Systematic And Unsystematic Risk

Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual risk," is the type of uncertainty that comes with the company or industry you invest in. Unsystematic risk can be reduced through diversification. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. Systematic risk, also known as "market risk" or "un-diversifiable risk", is the uncertainty inherent to the entire market or entire market segment. Also referred to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price. Volatility is a measure of risk because it refers to the behavior, or "temperament," of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be mitigated only by being hedged.

Systematic risk underlies all other investment risks. If there is inflation, you can invest in securities in inflation-resistant economic sectors. If interest rates are high, you can sell your utility stocks and move into newly issued bonds. However, if the entire economy underperforms, then the best you can do is attempt to find investments that will weather the storm better than the broader market. Popular examples are defensive industry stocks, for example, or bearish options strategies.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. In other words, beta gives a sense of a stock's market risk compared to the greater market. Beta is also used to compare a stock's market risk to that of other stocks. Investment analysts use the Greek letter 'ß' to represent beta. Beta is used in the capital asset pricing model (CAPM), as we described in the previous section.

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

Many utility stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

Beta helps us to understand the concepts of passive and active risk. The graph below shows a time series of returns (each data point labeled "+") for a particular portfolio R(p) versus the market return R(m). The returns are cash-adjusted, so the point at which the x and y axes intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us to quantify the passive, or beta, risk and the active risk, which we refer to as alpha.



The gradient of the line is its beta. For example, a gradient of 1.0 indicates that for every unit increase of market return, the portfolio return also increases by one unit. A manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk (i.e., a beta greater than 1) or alternatively decrease portfolio risk (and return) by reducing the portfolio beta below 1. Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return. Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company. (For further reading, see Beta: Know The Risk.)

Investors expecting the market to be bullish may choose funds exhibiting high betas, which increase investors' chances of beating the market. If an investor expects the market to be bearish in the near future, the funds that have betas less than 1 are a good choice because they would be expected to decline less in value than the index. For example, if a fund had a beta of 0.5 and the S&P 500 declined 6%, the fund would be expected to decline only 3%. (Learn more about volatility in Understanding Volatility Measurements and Build Diversity Through Beta.)

Here is a basic guide to various betas:

  • Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is possible but highly unlikely. Some investors used to believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declined, but this hasn't proved to be true over the long term.
  • Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
  • Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). Many utilities fall in this range.
  • Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market against which other stocks and their betas are measured. The S&P 500 is such an index. If a stock has a beta of 1, it will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.
  • Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Many technology companies on the Nasdaq have a beta higher than 1.
  • Beta greater than 100 - This is impossible as it essentially denotes a volatility that is 100 times greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock market. If you ever see a beta of over 100 on a research site, it is usually either the result of a statistical error or a sign that the given stock has experienced large swings due to low liquidity, such as an over-the-counter stock. For the most part, stocks of well-known companies rarely have a beta higher than 4.
Why You Should Understand Beta
Are you prepared to take a loss on your investments? Many people are not and therefore opt for investments with low volatility. Other people are willing to take on additional risk because with it comes the possibility of increased reward. It is very important that investors not only have a good understanding of their risk tolerance, but also know which investments match their risk preferences.

By using beta to measure volatility, you can better choose those securities that meet your criteria for risk. Investors who are very risk-averse should put their money into investments with low betas such as utility stocks and Treasury bills. Those investors who are willing to take on more risk may want to invest in stocks with higher betas.

Many brokerage firms calculate the betas of securities they trade, and then publish their calculations in a beta book. These books offer estimates of the beta for almost any publicly-traded company. The problem is that most of us don't have access to these brokerage books, and the calculation for beta can often be confusing, even for experienced investors.

However, there are other resources. One of the better-known websites as of 2012 that publishes beta is Yahoo! Finance (enter a company's name, then click on Key Statistics and look under Stock Price History). The beta calculated on Yahoo! compares the activity of the stock over the last five years and compares it to the S&P 500. A beta of "0.00" simply means that the stock either is a new issue or doesn't yet have a beta calculated for it.

Warnings about Beta
The most important caveat for using beta to make investment decisions is that beta is a historical measure of a stock's volatility. Past beta figures or historical volatility do not necessarily predict future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee that in a year the beta will be the same. One study by Gene Fama and Ken French called "The Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of Finance) on the reliability of past beta concluded that for individual stocks past beta is not a good predictor of future beta. An interesting finding in this study is that betas seem to revert back to the mean. This means that higher betas tend to fall back toward 1 and lower betas tend to rise toward 1.

The second caveat for using beta is that it is a measure of systematic risk, which is the risk that the market as a whole faces. The market index to which a stock is being compared is affected by market-wide risks. So, since it is found by comparing the volatility of a stock to the index, beta only takes into account the effects of market-wide risks on the stock. The other risks companies face are firm-specific risks, which are not grasped fully in the beta measure. So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks faced by the company alone.

The following is a chart of IBM's stock for the trading period of June 2004 to June 2005. The red line is the IBM percent change over the period and the green line is the percent change of the S&P 500. This chart helps to illustrate how IBM moved in relation to the market, as represented by the S&P 500 during the one-year period.



On June 8, 2005, the beta for IBM on Yahoo! was 1.636, meaning that up to that point, IBM had the tendency to move more sharply in either direction compared to the S&P 500. The chart above demonstrates IBM's tendency for higher volatility. When the market moved up, IBM (red line) tended to move up more (see the Oct.-to-Dec. range), and IBM's stock fell more than the market when it declined (see the Jan.-to-Mar. range). The large drop in IBM stock from Mar to Apr 2005, while coinciding with a smaller drop in the S&P, resulted from a firm-specific risk: the company missed its earnings estimates.

By showing IBM's behavior over this period, this chart demonstrates both the value that comes with the use of beta and the caution that needs to be shown when using it. It helps measure volatility, but it is not the whole story.

Analysts, brokers and planners have used beta for decades to help them determine the risk level of an investment, and you should be aware of this risk measure in your investment decision-making.



comments powered by Disqus
Trading Center