Beta as a measure of volatility
Course 3: Investment Planning
Lesson 1: Key Principles of Investing
Student Question:
I am having a difficult time conceptualizing Beta as a measure of only systematic risk AND as a measure of volatility relative to the broader market.
By way of illustration, assume an individual equity has wild swings in value over a one-year period (volatility) because of unsystematic factors (it lost a key contract government and then got a boost from a merger rumor and then discovered a cure for cancer and was then the subject of a government investigation).
Won’t those swings in value show up in the equity’s Beta?
Thank you for any help you can give.
Instructor Response:
Good to hear from you. Great question here.
Let’s start with why does Beta only measure systematic risk?
Beta reflects how a stock’s returns move in relation to the broader market. When Beta is calculated, it evaluates the covariance between the stock’s returns and the market returns. This statistical relationship filters out any noise caused by factors unrelated to the market.
Unsystematic events—such as losing a major contract, merger rumors, or investigations—affect a stock’s price independently of market movements. These events may cause significant price fluctuations (volatility), but since they don’t correlate with the overall market, they don’t significantly affect Beta. Beta specifically measures the portion of volatility tied to market movements (systematic risk).
Key Takeaways
- Beta captures volatility tied to market-wide (systematic) risk.
- Unsystematic risk can cause major price swings, but these don’t significantly influence Beta unless they coincide with market movements.
- Total Volatility = Systematic Risk + Unsystematic Risk. Beta measures only systematic risk.
So, while firm-specific events can lead to large price swings, they will not increase Beta unless those swings align with the broader market’s behavior.
Let me know if you have any other questions.
