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Beta as a Measure of Risk

Course: Investment Planning
Lesson 1: Key Principles of Investing

Student Question:

Hi Dan-

I don’t understand why this statement is true: “Beta is a measure of systematic, non-diversifiable risk.”

I thought Beta was a measure ofrelative volatility?

This is from a Board-Related Question in “Measures of Investment Risk” in “Principles of Investing”.

Craig

Instructor Response:

HI Craig,

Good question and a key concept to know for the CFP Board Exam.

  • Beta measures the volatility of my security or portfolio compared to the “market.”
  • Beta answers the question, “How volatile is my portfolio vs. the market?”

The “market” in this case is an appropriate benchmark.

  • For example, if my portfolio is comprised solely of large cap securities, then the “market” for the beta calculation would likely be the S&P 500 index.

Beta measures ONLY Systematic risk.

  • Systematic risk includes only inflation risk, reinvestment rate risk, interest rate, market risk, and exchange rate risk.
  • According to the theories tested on the CFP Board Exam, you cannot diversify out of systematic risk.
    • Systematic risk cannot be diversified away.

Beta measures only systematic risk because Beta ignores all other investment risks (nonsystematic risks).

Let me know how fully this addresses your question.

Bruce