The simplest definition of beta is that it is a measure of risk

by James Godrich

Fund Manager

Understanding Finance

The simplest definition of beta is that it is a measure of risk. Whilst I won’t derive the mathematics from first principles, it is worth saying that it is calculated by taking the correlation of an asset to an underlying collection of assets (like perhaps an index) and multiplying this by that same asset’s volatility, relative to that of the index.

The resulting number shows the historic impact on the asset price from a certain percentage move in the underlying index. So for example a stock with a beta of 1.2, would be expected to show a 12% increase/decrease from a corresponding 10% move in the index. Similarly a stock with a beta of 0.8 would be expected to show an 8% move from the same 10% change in the index.

Whilst this is a useful measure of portfolio risk and risk management, a more interesting use might be as part of an active strategy to generate outperformance based on a macroeconomic view. If I were to subscribe to the much talked about view of synchronised global growth for example, I might consider higher beta regions such as Japan and Europe. Likewise in time of greater uncertainty I may look to overweight lower beta regions such as the UK and US.

The problem with beta though comes from the disclaimer seen at the bottom of all financial investments; ‘past performance is not an indicator of future performance’. Whilst correlations may have existed in the past, this can’t guarantee the continuation of that relationship which could be impacted by any number of fundamental changes.


Understanding Finance

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