Evaluating a potential share for inclusion into a portfolio can certainly be accomplished innumer- able ways. From the highly advanced methods of a professional ‘quant’ fund manager, right down to using a dart as the main selection tool, every investor will have their preferred method. Most cer- tainly though careful analysis of each equity is required to create a portfolio that abides by our per- sonal tolerance for risk. That is, the fluctuations and gyrations of our investments should not cause us to suddenly hyperventilate, throw down 4 shots of Pepe Lopez in quick succession, and then pro- ceed to run through the streets screaming ‘sell everything’!
Therefore, it is a good idea to have at least a couple of indicators which can aid us in establishing which prospective candidates may be suitable for inclusion in our portfolio. A good example is the ‘beta’ value calculated for all listed securities.
The real ‘beta’ calculation can be considered reasonably straightforward, but for those with a mathematics aversion (most of us) thankfully we don’t have to do it. Being a common volatility measure, share betas are already calculated and freely available to us through many avenues such as direct broker sites etc. An important point to remember though is that a share’s beta is a calculation based on historical price movements and is certainly not infallible; it is only a reasonable guide and certainly not perfection.
Quite simply, a shares beta is a numerical representation of how its price moves in relation to the total market movement to which it belongs. The resulting calculation provides us with a number either greater or less than 1.0 which we can then use as a comparison to our market benchmark (1.0).
Because it is an indicator or measure of a securities market risk (non-diversifiable risk), the more responsive a share will be to market movements, the higher will be it’s ‘beta’ number and the less responsive a security gives it a lower ‘beta’ number.
I know it sounds a bit like a year 12 maths classes all over again, but, ‘beta’ values are fairly easy to interpret and that folks is really all that matters. Generally speaking, if a share experiences movements that are greater – more volatile – than the total stock market, then the beta value will be
greater than 1. If a stock’s price movements, or swings, are less than those of the market, then the beta value will be less than 1; so far so good.
Okay, let’s look at a particular share with a beta number of 1.25. We can presume that if the total market moves up by 2% our share should go up by a 25% greater amount. Should the total market fall, our share will probably fall by a 25% greater amount than the market. Alternatively, if the beta number was 0.50 it would be safe to assume that when the overall market goes up your share would be expected to in- crease in value by only 50% of that increase. Alternately, when the total market falls, this particular share should only fall by 50% of the total markets decline. No doubt, probably as clear as mud! I have put a chart below to give some guidance
| Beta | Comment | Interpretation |
| 2.00 | The share will move in the | Twice as responsive as market |
| 1.00 | same direction as the market | Same response as market |
| 0.50 | One-half as responsive as market |
NB Beta numbers can also be negative, although rare, but interpretation is similar
Using the beta number
The most obvious use of beta numbers is to give a reasonably good idea about how selected shares in a portfolio will respond over time to market action. It is certainly a good way to blend a portfolio be- cause as a measure of volatility, it can be used to find both high or low volatility shares. But always keep in mind, that when a stock’s beta is less than 1; you will get lower risk, but you must also then expect lower overall returns. On the other hand, shares with beta’s higher than 1.00 will have more risk but they should give you greater returns.
For example, you may want to build a portfolio of 6 shares and want it to be relatively low risk/volatility. As part of the selection process, you would use the beta number of candidates and only include those that have a number less than 1.00. Alternatively, if you wanted to create a high-
performance portfolio you would select all high-beta shares. In both cases, you would need to be mindful of the resulting performance probability for each portfolio.
If you are on the lookout for consistent dividend payers, particularly in the blue chip category, be aware that they usually come with low beta numbers. Therefore the inclusion of too many of these in your portfolio could result in low or possibly even no ‘real’ growth over time. Therefore, those of you building wealth need to look carefully at creating a ‘growth – mix’ consistent with set goals and risk appetite.
So there you have it, good old beta. Always remember though that beta is a very handy thing to have around and absolutely, should be added to your investment ‘toolkit’. But nothing is 100% correct so always use a number of analytical tools to give you the greatest probability of success.
