This week we’re launching a new category of short articles titled “Learn About __________.” The goal of these articles is to provide a quick summary of commonly used terms that you may come across in the world of finance. This week we’ll talk about Beta, a commonly used measure of systematic or market-related risk.
In finance, Beta (or β) is a measure of volatility based on how correlated a security’s returns are with those of the overall market. If a security has a beta of 1 it moves perfectly with the market (if the market goes up a percent, the security goes up a percent, if the market drops a percent, the security drops a percent, etc.). If a security has a beta of -1, it moves inversely to the market (falls when the market rises and rises when the market falls). Beta is found using a regression analysis and is calculated by dividing the covariance of a security’s returns by the variance of the market’s returns. This is done using historical returns so it’s important to note that Beta is not a predictor of future performance but a reflection of a security’s relationship with the market in the past. Beta is only useful if it is accompanied by a high R-squared (don’t worry – we’ll explain R-squared in a future article).
Understanding Beta can be helpful when it comes to estimating the volatility of a given security (how much it moves up and down) especially in relation to how the market (or some other benchmark) moves. Beta is also used in other financial equations such as the Capital Asset Pricing Model (CAPM) which is used to estimate the expected price of risky securities.