Investors need to concern themselves with the risk of their investments as well as the return. Kyle Tetting explains how they can weigh potential risk by studying its beta, which measures relative volatility versus a benchmark. Kyle spoke with Joel Dresang in a Money Talk Video. A transcript follows.

Joel Dresang: Kyle, when you hold a magnifying glass to an investment portfolio, one of the things that you zoom in on is the beta. Remind us again what that is.

Kyle Tetting: Ultimately, beta is really our way to measure the risk of a portfolio or even of a particular investment, but our way of measuring that relative to a benchmark.

Joel: And why is that important?

Kyle: We really believe in risk-first allocation here. Our first objective is to set an asset allocation for clients that really tailors a portfolio to a level of risk. So our way of measuring that is beta, and that’s why it’s so important for us and it’s one of the tools that we use to get a sense of where the portfolio is.

Joel: So it’s measuring risk because of the need for preservation of wealth.

Kyle: Yeah. You know, it really tells us, okay, relative to the benchmark, what can we expect this portfolio to do? So that if we’re looking at a market that is significantly down, we should expect some percentage of that decrease based on what our beta is.

And it’s really a one-for-one trade. You know, a beta of 1 relative to a benchmark tells us that we’re going to be even with that benchmark. The market goes up 10 percent, our benchmark goes up 10. At a beta of 1, our portfolio also should go up 10. And every degree of that beta, then, tells us that relationship. So a beta of 0.5 would be 50 percent of the movement of the market.

Joel: So it’s measuring the sensitivity of an investment to some given benchmark?

Kyle: That’s absolutely right.

Joel: How do you pick the benchmark?

Kyle: It’s more often than not something that is as simple as saying here’s what you see most often. So one of the most quoted benchmarks for the U.S. stock market is the S&P 500. So if you’re looking at a specific investment, say a stock, and you’re on a financial website, you might see the beta quoted. That beta is going to be quoted relative to the S&P 500. It gets a little bit more tricky when we’re building portfolios. We don’t have to use the S&P 500. We can build a benchmark that more closely tracks what it is we are building. So if we have a portfolio that’s 60 percent stocks, 40 percent bonds, we can build that benchmark and then measure the volatility relative to it.

Joel: And how easy is it for you and other investors to find the beta?

Kyle: It’s fairly easy. You know, we pay for tools. We use Morningstar, and we pay for them to give us that data. But you could do the math on your own. Every finance student in Finance 101 learns how to calculate beta. And I think really it’s whether or not you trust the data from the website you’re going to or from the data that you’re paying for. We have a very good relationship with Morningstar. We very much trust the data they give us, but knowing we could go out there and get it ourselves if there were any discrepancies also is helpful.

Joel: So, to sum up, what is the most important thing investors should know about beta?

Kyle: I think for investors, the most important thing about beta is that it really gives them an idea of how volatile their portfolio should be relative to a benchmark. You know, it’s easy for us to say the S&P 500 – because that’s what they’re going to see on the news. Here’s what you can expect your portfolio to do, relative to that benchmark.

Joel: Kyle, what kinds of shortcomings should investors know about?

Kyle: I think that the biggest issue with beta is that you can really use it to describe anything you want. So while that’s a great tool, it can also provide some pretty big challenges in that it isn’t as easy as just saying that it’s your relationship between your investment and some underlying benchmark. You really want to make sure that those two are related in some way.

So it’s like saying I’m going to buy this small-cap stock, and I want to know what the beta is, relative to the S&P 500. Well, the S&P 500 is a large-cap, blended index, as opposed to that small-cap stock that has nothing to do with that. You know, one doesn’t really isn’t going to explain the performance of the other.

Joel: So it’s trying to measure apples against apples.

Kyle: Yes. You want to make sure you’re measuring applies against apples, and that’s when beta really becomes useful. And you can start to measure what the actual risk is relative to the benchmark.

Joel: And we have the R-squared to help us determine whether the beta is accurate.

Kyle: We’ve got that coefficient of determination there. It really tells us how well the data fits that relationship. So the higher the R-square, up to 100, the more accurate that data is going to be, the more accurate that fit is going to be between the two things you’re measuring. The lower it is, the worse the fit.

Joel: And it’s also historically based, so that’s not necessarily predicting what’s going to happen.

Kyle: That’s absolutely correct. And that’s an important point. It doesn’t tell you what’s going to happen for your portfolio or for the market. Many things can change the relationship between two different portfolios or a portfolio and an index. But it does tell you over time this has been the relationship.

Kyle Tetting is director of research at Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted May 8, 2014)

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Learn more
Watch Kyle Tetting in Talking Money: Modern Portfolio Theory
as well as in Talking Money: Measuring risk and reward
and in Correlation: A tool for balancing investment assets
Also, learn about the Efficient Frontier in balanced investing from Steve Giles