Diversification is a key element of building any successful portfolio. Spreading your investment across a wide range of companies, asset classes, industries and sectors helps protect you against market volatility to a great extent. Diversification also helps you enjoy steady growth in your portfolio without suffering crazy swings. Beta becomes a very important factor in this case. The beta represents the sensitivity of a given stock to the changes occurring in the market overall. Calculating beta of your portfolio isn’t really complicated and you can use basic mathematics to calculate it. In this post, we will discuss what beta is, how to calculate your portfolio’s beta value and how to find beta. Let’s get started.
What is Portfolio Beta and How to Calculate it?
What is beta?
Beta measures a given stock’s volatility in relation to the market overall. Technically speaking, a market, such as the S&P 500 index will always have a beta of 1.0. A stock’s deviation from the market decides its ranking. A stock that swings more than the market itself, carries a beta of more than 1.0, while a stock that swings less than the market, has a beta of less than 1.0. Investing in high beta stocks might provide higher returns, but they also come with much higher risks. On the other hand, low beta stocks provide lower returns but are a lot safer.
What is portfolio beta?
A portfolio beta is nothing but the weighted sum of the individual asset betas. If your portfolio consists of two stocks and half of your money is in Stock X with a beta of 2.00 and the remaining in Stock Y with a beta of 1.00, your portfolio beta is 1.50. Portfolio beta describes the relative volatility of a securities investment portfolio.
How to calculate beta?
First things first, you must try and understand that beta is measured on a scale comparing the individual investment to a benchmark index like the S&P 500. A beta of “1.0” indicates that the investment’s volatility is the same as the benchmark’s. This means that the investment’s value will fluctuate like the benchmark itself. In other words, a number higher than “1.0” indicates more volatility than the benchmark, while lower numbers indicate more stability. For example, a stock with a beta of 1.2 is 20% more volatile than the market. So if the market falls by 10%, the stock will witness a 12% drop. Conversely, if a stock has a beta of 08, it will only suffer a 8% drop when the market drops by 10%.
Individual investors can examine the beta of each holding, perform a simple calculation and determine the volatility of their portfolios. The calculation is simply a matter of adding up the beta for each security, and adjusting according to how much of each you own. This results in the weighted average of all the betas.
How to calculate beta for your stock portfolio
The beta values for individual stocks can be found on the websites of most online discount brokerages or reliable publishers of investment research. In order to calculate the portfolio beta, you need to follow these steps:
- Add up the value (number of shares x share price) of each stock you own and your entire portfolio.
- Based on these values, determine how much you have of each stock as a percentage of the overall portfolio.
- Take the percentage figures and multiply them with each stock’s beta value. For example, if 25% of your portfolio comprises of Apple and it has a beta of 1.43, its weighted beta would amount to 0.3575.
- Add up the weighted beta figures and that gives you your portfolio beta.
How to calculate beta for individual stocks
In most cases, you will not be required to calculate the beta of individual stocks as those figures are readily available online. However, if you are one of those investors who like crunching numbers by themselves, learning to calculate the beta of individual stocks is good for you. The beta of individual stocks can be calculated across different time periods. Stocks can prove to be volatile over the short term but are generally stable over many years. Because of this, investors might want to calculate the beta themselves (so that they can get a more accurate value). Another advantage of calculating the beta of individual stocks is that you can calculate it against different benchmarks. For example, you may believe that a stock with a heavy presence overseas is best judged against an international index instead of the S&P 500.
Calculating beta of individual stocks by yourself can also help you learn about price movements in great detail. There are some very complicated models for the calculation of stock betas, however, we will provide a simple, easy to understand version for you. Here are the steps you need to follow:
- First of all. Get a spreadsheet program to assist with calculations. Then you should determine the range of time you intend to measure.
- Using the spreadsheet program, enter the closing share price for your stock on each day of the date range you’ve selected. Repeat the process for the index you are comparing the stock to. Determine the change in price and the change on a percentage basis for every single day.
- After that, use the formula mentioned below to figure out how the stock and index move together and how the index moves by itself.
- The formula is: (Stock’s Daily Change % x Index’s Daily % Change) ÷ Index’s Daily % Change.
And there you have it, the beta of an individual stock in relation to the benchmark index of your choice. Hopefully, this information will help you diversify your portfolio even better with the help of beta values.