A:

In financial/investment terminology, beta is a measurement of volatility or risk. Expressed as a numeral, it shows how the variance of an asset – anything from an individual security to an entire portfolio – relates to the covariance of that asset and the stock market (or whatever benchmark is being used) as a whole.  Or as a formula:

What is Beta?

Let's break down this definition further.  When you have exposure to any market, whether it's 1% of your funds or 100%, you are exposed to systematic risk. Systematic risk is undiversifiable, measurable, inherent and unavoidable.  The concept of risk is expressed as a standard deviation of return.  When it comes to past returns – be they up, down, whatever – we want to determine the amount of variance in them. By finding this historical variance, we can estimate future variance. In other words, we are taking the known returns of an asset over some period, and using these returns to find the variance over that period. This is the denominator in the calculation of beta. (Want to learn more about excel? Take Investopedia's excel courses online.) 

Next, we need to compare this variance to something.  The something is usually "the market." Although "the market" really means "the entire market" (as in all risk assets in the universe), when most people refer to "the market"  they are typically referring to the U.S. stock market and, more specifically, the S&P 500. In any event, by comparing our asset's variance to that of "the market," we can see its inherent amount of risk relative to the overall market's inherent risk: This measurement is called covariance.  This is the numerator in the calculation of beta. 

Interpreting betas is a core component in many financial projections and investment strategies. 

 

Calculating Beta in Excel

It may seem redundant to calculate beta, since it's a widely used and publicly available metric. But there's one reason to do it manually: the fact that that different sources use different time periods in calculating returns.  While beta always involves the measurement of variance and covariance over a period, there is no universal, agreed-upon length of that period. Therefore, one financial vendor may use five years of monthly data (60 periods over five years), while another may use one year of weekly data (52 periods over one year) in coming up with a beta number.  The resultant differences in beta may not be huge, but consistency can be crucial in making comparisons. 

To calculate beta in Excel:

  1. Download historical security prices for the asset whose beta you want to measure.
  2. Download historical security prices for the comparison benchmark.
  3. Calculate the percent change period to period for both the asset and the benchmark. If using daily data, it's each day; weekly data, each week, etc.
  4. Find the Variance of the asset using =VAR.S(all the percent changes of the asset).
  5. Find the Covariance of asset to the benchmark using =COVARIANCE.S(all the percent changes of the asset, all the percent changes of the benchmark).

 

Issues with Beta

If something has a beta of 1, it's often assumed that asset will go up or down exactly as much as the market. This definitely is a bastardization of the concept. If something has a beta of 1, it really means that, given a change in the benchmark, its sensitivity of returns is equal to that of the benchmark.  

What if there are not daily, weekly, or monthly changes to assess?  For example, a rare collection of baseball cards still has a beta, but it cannot be calculated using the above method if the last collector sold it 10 years ago, and you get it appraised at today's value.  By only using two data points (purchase price 10 years ago and value today) you would dramatically underestimate the true variance of those returns.  

The solution is to calculate a project beta using the Pure-Play method. This method takes the beta of a publicly traded comparable, unlevers it, then relevers it to match the capital structure of the project. 

 

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