What is the beta of a stock? Overview and Explanation

I went to Yahoo Finance and I obtained the betas for 10 different us-based firms. I've got the betas in the right column, so you see Alcoa, for example, an aluminum company the beta is 0.28 whereas for Walmart the beta is 0.38. Just a quick review of what beta is when we think about the risk of a firm stock we think about unsystematic firm-specific risk which can be diversified away and we think about the systemic risk that's related to the market as a whole and cannot be diversified away and beta is a measure of this systemic risk. So for a 1% change in the market portfolio, if the market portfolio were to go up 1% beta is the percentage change in the stock return.

So let's apply this to an actual firm, so if the market portfolio of all the assets, all the different firms that are out there if that portfolio were to increase by 1% point then the return for Alcoa would increase by 0.28% points so that's a just quick review of what the beta is. Now we can see the firms with a beta of less than one, we've got Bank of America, Intel, Walmart, and Alcoa have less systemic risk than the average firm. These other firms here have a beta of higher than one have more systemic risk than the average firms. The systemic risk of the average firm would be just 1.0 so if you're higher than 1 you have more systemic risk than average. What does that mean that means? Well if we take for example General Motors, when the market goes up General Motors also goes up but it goes up even more than the remaining other of the market, and when the market goes down General Motors falls even further than the market. That's what we say that it has more systemic risk than average.

Now for example, if there was a firm that had a beta of 0, that would mean that that firm has no systemic risk. It basically means it doesn't react to any market-wide movements or anything like that. It's also possible you could even have a firm that has a negative beta and this is probably not going to make much sense to you and will make even less sense when we get into the capital asset pricing model. The negative beta basically means that the firm has a negative risk premium and that means that the firm the return is less than the risk-free rate and so you might say "Why would an investor ever invest in something that has a return that is less than the risk-free rate?" The reason is that a negative beta is basically like having insurance for when the market goes bad because a negative beta is a firm that it's going to do really well when the rest of the market is collapsing. You can kind of see it as an investor adding a firm like that to their portfolio as insurance in case things don't go so well in the market. Just bear in mind that negative beta is very rare and also you're probably not going to see any firms of the beta of 0, so most betas will look positive.

The bottom line to remember, as we get into the capital asset pricing model which we're going to talk about soon, is that a beta is higher than 1 means the firm has more systemic risk than average, and a beta of less than 1 means that the firm has less systemic risk than average in it. It makes intuitive sense if you think about it for example take Walmart. Walmart is a retailer that also sells groceries now. If the market collapses and there are problems people aren't going to stop buying groceries. They're probably not going to stop shopping at Walmart. In fact, some people might actually start shopping more at Walmart instead of like a place like Whole Foods Market. Walmart is going to have a much lower beta, they're not going to have some beta like 2.5 or something like that. So, people are going to shop at Walmart kind of irrespective of what the overall market conditions are so Walmart doesn't have as much systematic risk.

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