Beta and portfolio diversification

Beta
Beta is a notion that assesses the projected movement of a stock in relation to market changes as
a whole. A stock is thought to be less volatile if its beta is less than 1.0 and more volatile if it is
bigger than the general market.

The formula is given below:

Cov ( r i , r m )
βi=
Var ( r m )

βi = Market beta of asset i

Cov = covariance

Var = variance

r m = average expected rate of return on the market

r i = expected return on an asset i

Understanding of beta points:

Beta Stock vs. Market

>1 High correlation Higher volatility

1 High correlation same volatility
0 to 1 Slightly correlation Lower volatility
0 No correlation
-1 to 0 Slightly inverse correlation Lower volatility
-1 High inverse correlation same volatility
<-1 High inverse correlation Higher volatility

Beta example: A beta that is greater than 1.0 indicates that the security's price is theoretically
more volatile than the market. For example, if a stock's beta is 1.2, it is assumed to be 20% more
volatile than the market. Technology stocks and small cap stocks tend to have higher betas than
the market benchmark.

How to calculate Beta: Beta could be calculated by first dividing the security's standard
deviation of returns by the benchmark's standard deviation of returns. The resulting value is
multiplied by the correlation of the security's returns and the benchmark's returns.

Finding beta of a stock using formula:

 1. Get the historical prices for the desired stock.
2. Get the historical prices for the comparison benchmark index.
3. Calculate % change for the same period for both the stock and the benchmark index.
4. Calculate the Variance of the stock.
5. Find the covariance of the stock to the bench.

What is beta asset?

Unlevered beta (or asset beta) measures the market risk of the company without the impact of
debt. 'Unlevering' a beta removes the financial effects of leverage thus isolating the risk due
solely to company assets.

Examples of beta

High β – A company with a β that’s greater than 1 is more volatile than the market. For example,
a high-risk technology company with a β of 1.75 would have returned 175% of what the market
returned in a given period (typically measured weekly).

Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an
example, consider an electric utility company with a β of 0.45, which would have returned only
45% of what the market returned in a given period.

Negative β – A company with a negative β is negatively correlated to the returns of the market.
For example, a gold company with a β of -0.2, which would have returned -2% when the market
was up 10%.

Advantages of beta testing:

 Beta offers a clear, quantifiable measure that is easy to work with.

 If you think about risk as the possibility of a stock losing its value, beta has appeal as a
proxy for risk.

Disadvantages of Beta:

 Beta doesn't incorporate new information.

 Relatively new stocks have insufficient price history to establish a reliable beta and
 Past price movement is a poor predictor of the future.

Portfolio diversification
What is meant by portfolio diversification?

Portfolio diversification is the process of investing your money in different asset classes and
securities in order to minimize the overall risk of the portfolio. Just imagine what would happen
if you invested all your money in a single security. Everything would be great as long as the
stock's performance is good.

What is a diversified portfolio and why is it important: When you diversify your portfolio,
you incorporate a variety of different asset types into your portfolio. Diversification can help
reduce your portfolio's risk so that one asset or asset class's performance doesn't affect your
entire portfolio.

Types of diversified portfolio:

1. Industry diversification.
2. Individual company diversification.
3. Asset class diversification.
4. Strategy diversification.
5. Time diversification.
6. Alternative asset diversification.
7. Geographic diversification.

What is a diversified portfolio example?

In other words, investors use diversification to avoid the huge losses that can happen by putting
all of their eggs in one basket. For example, when you diversify, you allocate a portion of your
investments to riskier stock market trading, which you spread out across different types of stocks
and companies.

What are the benefits of portfolio diversification?

 Reduces the impact of market volatility.

 Reduces the time spent in monitoring the portfolio.
 Helps seek advantage of different investment instruments.
 Helps achieve long-term investment plans.
 Helps avail of benefit of compounding of interest.
 Helps keep the capital safe.
What does a diversified portfolio looks like? An example is given below:

Protfolio Diversification
5
15

stock 15

35 bond 18
18 gold 27
property 35
others 5

27