Definition of 'Beta'

The Beta coefficient (), in terms of finance and investing, is a measure of a stock's (or
portfolio's) volatility in relation to the rest of the market. Beta is calculated for individual
companies using regression analysis.
The beta coefficient is a key parameter in the capital asset pricing model (or CAPM).
It measures the part of the asset's statistical variance that cannot be mitigated by the
diversification provided by the portfolio of many risky assets, because it is correlated with
the return of the other assets that are in the portfolio.
There are several misconceptions about beta. Amongst the most common are:

Beta measures the relative volatility of a security's price compared to the price of
the market. Beta is a measure that compares returns, not prices; a security with a
positive beta can have a price that decreases while the market's price increases. The key is
whether the security's returns are above or below its mean return when the market's
returns are above or below its mean return; whether the security's mean return is positive
or negative is not relevant to its beta.

Beta measures the relative volatility of a security's returns compared to the

volatility of the market's returns. Beta has two components: relative volatility of
returns, and correlation of returns. Unless the correlation of returns is +1.0 or -1.0, beta
does not measure the relative volatilities of returns.

A positive beta means that a security's returns and the market's returns tend to
be positive and negative together; a negative beta means that when the market's
return is positive the security's return tends to be negative, and vice versa. The
calculation of beta involves deviations of the market's returns and the security's returns
about their respective mean returns. A security with a negative mean return can have a
positive beta, and a security with a positive mean return can have a negative beta.

A beta of 1.0 means that the security's returns have the same volatility as the
market's returns. This could be true, or the security's returns could be twice as volatile
as the market's returns, but their correlation of returns is +0.5. Beta, by itself, does not
describe the relative volatility of returns.

Applications of Beta
Beta is a commonly used tool for evaluating the performance of a fund manager. Beta is used
in contrast with Alpha to denote which portion of the fund's returns are a result of simply
riding swings in the overall market, and which portion of the funds returns are a result of

truly outperforming the market in the long term. For example, it is relatively easy for a fund
manager to create a fund that would go up twice as much as the S&P 500 when the S&P rose
in value, but go down twice as much as the S&P when the S&P's price fell - but such a fund
would be considered to have pure Beta, and no alpha. A fund manager who is producing
Alpha would have a fund that outperformed the S&P 500 in both good times and bad.
Beta can also be used to give investors an estimate on a stock's expected returns relative to
the market return. Consider some examples:

Company ABC, a tech stock, has a beta of 1.8. Over a given year, the NASDAQ
Composite Index increases in value 17%. Assuming the beta value is accurate, ABC's
value should have increased 30.1% or (1.8 x 17%) over the same time period.

Company XYZ, a mid-sized oil company, has a beta of 1.0. Over a given year,
the S&P 500 Index falls 8%. Assuming the beta value is accurate, XYZ's value would
also have fallen 8% over the same period.

Company LMN, a gold mining company, has a beta of -1.4. Over a given year,
the S&P 500 Index increases in value 11%. Assuming the beta value is accurate, LMN's
value would have declined 15.4% or (-1.4 x 11%) over the same period.
There are, however, significant disadvantages to beta.

1. Its calculated from historical data (and hence does not capture future changes in the
market), and of course depends on the chosen time period.
2. Beta does not discriminate between upwards volatility and downwards volatility.
3. It assumes that volatility is described by a normal distribution this isnt always the
case

Example: You are given the following information about the market portfolio and
McWilliams Company:
State of nature

probability

Market return
R
( m )

McWilliams Equity Return

R
( i )

0.1

-0.15

-0.30

0.3

0.05

0.10

0.4

0.15

0.30

0.2

0.20

0.40

What is the beta of the McWilliams Company?

Calculation of market parameters
State of
nature (S)

Probability
(Ps)

Market return
(Rm)

1
2
3
4

0.1
0.30
0.04
0.20

- 0.15
0.05
0.15
0.20

Ps(Rm)

(Rm
R

-0.02
0.02
0.06
0.04

E( Rm )

( RmR m)2

Ps
(RmR m)2

m)

-0.25
-0.05
0.05
0.10

0.0625
0.0025
0.0025
0.0100

0.0063
0.0008
0.0010
0.0020
Var (Rm)=.01

= 0.10

Calculation of expected return and covariance of McWilliams Company

S

Ri

Ps

Ps(

Ri

Ri

R i )
1
2
3
4

0.1
0.30
0.04
0.20

- 0.30
0.10
0.30
0.40
E(

-0.03
0.03
0.12
0.08
R i

(Rm- R

m)

(Rm- R m)

-0.50
-0.10
0.10
0.20

i.

Ps (

0.02
.01

= 2.0

Ri

- Ri )

(Rm- R m)

0.125
0.005
0.005
0.020
02

We know,
Cov ( Ri , R m)
Var ( Rm)

- Ri )

Cov (

)=

0.20

-0.25
-0.05
0.05
0.10

Ri

0.0125
0.0015
0.0020
0.0040
Ri , R m

)=.