The Importance of Measuring Risk in Financial Markets
In the financial market, measuring risk might be as significant as measuring the expected investment returns. The Capital Asset Pricing Model (CAPM) provides excellent utility in calculating investment riskiness (Titman, Keown, & Martin, 2017). It is based on assessing an investment’s systematic and unsystematic risks in relation to the market portfolio – a concept that includes all of the economy’s assets (Titman et al., 2017). Whereas the latter risk tends to be diversified away when investments combine, the former affects the return on all the investments, highlighting the importance of its computation.
Systematic Risk and Its Calculation: Understanding the Beta Coefficient
The broad impact of systematic risks on returns allows for a relatively straightforward computation. In particular, according to Titman, Keown, and Martin (2017), an investment’s systematic risk can be measured “using the extent to which the returns of the investment correlate with the returns of the overall market portfolio” (p. 267).
In this context, an investment’s systematic risk is referred to as its beta coefficient. It compares the returns on a particular investment with the returns on a market portfolio (Titman et al. 2017). Analogously to investment return, beta can also measure the volatility of a particular stock in comparison to the whole market’s systematic risk.
How Investors Use Beta
Overall, investors use beta to estimate how much risk an investment adds to a portfolio. While an investment does not deviate from the market, it does not add much risk to a portfolio. However, this way, it also does not have any potential for increasing returns. The beta coefficient can show the extent of that deviation by assuming different values, with one being the reference point.
An investment with a beta of 1.0 indicates its returns strongly correlate with the market (Titman et al., 2017). Therefore, adding this investment to a portfolio with a beta of 1.0 will not add any risk to the portfolio. Still, it also will not increase the likelihood of an excess return on that portfolio. A beta value less than 1.0 implies that the systematic risk is less volatile than the market. Thus, including this investment in a portfolio lowers the risk compared to the portfolio without the investment (Titman et al., 2017).
A beta greater than 1.0 means that the systematic risk is more volatile than the market. For instance, an investment’s beta of 1.2 assumes a 20% greater volatility than the market (Titman et al., 2017). Consequently, it indicates that adding this investment to a portfolio will increase the latter’s risk but with the potential to increase its expected returns.
Limitations of Beta as a Risk Measure
While beta can provide valuable insights when evaluating an investment, it has several limitations. Beta is undeniably helpful in determining a short-term systematic risk and assessing volatility to define equity costs during the CAPM’s application. However, since historical data points are the primary information source for beta calculation, they become less valuable for investors who seek to evaluate an investment’s future state (Titman et al., 2017).
Analogically, beta is less helpful in assessing long-term investments due to volatility’s tendency to change based on numerous factors. In other words, beta is unreliable as a stable risk measure. Therefore, it should be considered an essential complement but not a panacea in risk management.
References
Titman, S., Keown, A. J., & Martin, J. D. (2017). Financial management: Principles and application (13th ed.). Harlow, England: Pearson.
