Beta figures and how to use them

Diversification is the key to long-term investment returns, with defensive exposure outperforming relatively when markets fall and growth stocks outperforming when the markets move ahead. This brings us to the issue of beta, which is a measure of volatility against a benchmark, such as a gilt or an index, such as the S&P 500 or FTSE 100.

 

What is beta?

 

Firstly, it is crucial to recognise that beta is based on historical figures, but as history tends to repeat itself in investment markets, it does have a use. As we touched on above, beta, in this instance, is a measure of volatility against a benchmark.

 

If we use an index such as the S&P 500 as the basis (a beta of one), the range of beta figures will determine how specific investments/asset classes are likely to move compared to the market.

 

· A beta of one suggests that the asset in question will move in line with the market. This is relevant to index trackers designed to move in line with, for example, the S&P 500.

 

· A beta between zero and one indicates a defensive investment, which is less volatile than the market.

 

· A zero beta is for investments that have no correlation with the market, for example, cash or cash equivalents.

 

· A negative beta indicates that an investment would move in the opposite direction to the market, for example, an inverse ETF, which falls when the market rises and rises when the market falls.

 

· A beta greater than one suggests that an investment is more volatile than the market but will likely move in the same direction.

 

· A beta of two would identify an investment that is twice as volatile as the market, for example, technology and biotech stocks.

 

The formula for calculating the beta of your investment portfolio is relatively straightforward but can be cumbersome if you have a large number of investments.

 

Example of an investment portfolio beta calculation

 

In this instance, we will assemble a relatively simple portfolio and calculate the beta for the combined investments. The figures are as follows:-

 

· Investment one, portfolio weighting 20% with a beta of zero

· Investment two, portfolio weighting 10% with a beta of two

· Investment three, portfolio weighting 20% with a beta of one

· Investment four, portfolio weighting 30% with a beta of three

· Investment five, portfolio weighting 20% with a beta of minus one

 

To calculate the portfolio beta, we multiply the portfolio investment weightings by the beta and add the five figures. This is the result of the above portfolio:-

 

· Investment one, zero

· Investment two, 0.2

· Investment three, 0.2

· Investment four, 0.9

· Investment five, -0.2

 

The combined value of these beta calculations is 1.1, which means that the portfolio would be expected to be slightly more volatile than the underlying benchmark.

 

Putting asset classes into perspective

 

If we look at the broader investment market, taking in equities, bonds, real estate investment trusts, commodities, cash and alternative investments, this would be a typical scenario:-

 

Equities - they would typically have a beta greater than one, suggesting they would be more volatile than the broader market.

 

Bonds - often seen as defensive, they tend to have a beta of less than one, which means they are normally less volatile than the market.

 

Real estate investment trusts - due to a mix of gearing, equity and specific property risk, real estate investment trusts would likely have a beta higher than one.

 

Commodities - the beta for individual commodities can be relatively volatile, and some may even have a negative correlation with the market.

 

Cash/cash equivalents - this type of investment will have a zero beta because it is not impacted by the performance of the market.

 

Alternative investments - dependent upon the type of alternative investment, i.e. hedge funds, private equity, venture capital trust, the beta could be above or below one.

 

This is a relatively simplistic introduction to beta, markets and investment volatility. Still, it does allow you to structure your portfolio in line with your investment strategy and attitude to risk.

 

Summary

 

As you can see above, it is possible to switch/adjust your investments to impact the overall beta of your portfolio. While nothing is set in stone with beta valuations, the general long-term trends tend to remain in place and give a useful indication of potential performance against a specific benchmark

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