In the real world, Beta and Alpha bros might be pitted against each other. In finance, however, the concepts are best when they work together. 

Alpha measures if a stock has beaten the market’s return. Beta enhances that information. 

Keep reading this article to learn what Beta is, an analogy explaining it, how it relates to CAPM/Alpha, and why the application can assist your financing journey. 

What is Beta?

Beta (β) is a number that will appear in every stock screener you create with Equities Lab. When you create a screener, a table will pop up in the backtesting section with the Beta measurement for that particular screener. 

What is the number measuring? Beta measures a security or portfolio’s volatility and systematic risk compared to the whole market. 

Why is the measurement valuable? Because Beta allows you to see the sensitivity of your stock screener’s returns to the whole market. For example, using the 1st homework as a reference, the strategy has a Daily Beta of 0.8916. This shows low sensitivity to the market’s movements, making it a less volatile and less risky investment strategy based on the market. 

Lemonade Stand’s Beta

If you’re mulling over how Beta demonstrates sensitivity and volatility, this analogy may help! Barney has investors looking left and right, trying to figure out how he’s succeeding with his lemonade stand! 

The investors want to calculate how the lemonade stand does with varying events and activities going on around it. They want to test the risk involved in the business, so they evaluate one week with the data below. 

Day# of CustomersEvents/Activities
Monday25No
Tuesday30Yes (Art Fair)
Wednesday20No
Thursday23No
Friday 38Yes (Music Festival) 

The equation to calculate Beta is below. 

Beta (β) = Variance / Covariance

Calculating Averages: 

Average # of Customers per week (Y):

Y = (25 + 30 + 20 +23 +38) / 5

Y = 27.2

Average Events/Activities per week (X):

X = (0 + 1 + 0 + 0 +1) / 5

X = 0.4

Calculating Covariance: 

Cov (Y, X) = [(25 – 27.2) * (0 – 0.4) + (30 – 27.2) * (1 – 0.4) + (20- 27.1) * (0 – 0.4) + (23 – 27.2) * (0 – 0.4) + (38 – 27.2) * (1 – 0.4)] / 5 

Cov (Y, X) = 13.56 / 5

Covariance = 2.712

Calculating Variance:

Var (X) = [(0 – 0.4)^2 + (1 – 0.4)^2 + (0 – 0.4)^2 + (0 – 0.4)^2 + (1 – 0.4)^2] / 5 

1.2 / 5 = 0.24

Variance = 0.24

Calculating Beta: 

Beta (β) = Variance / Covariance

Beta (β) = 0.24 / 2.712

Beta (β) = 0.09

A beta of 0.09 would indicate that the lemonade stand has a low sensitivity to events/activities in the area and will maintain a certain amount of success regardless of outside factors. It is at low risk because it will succeed, which is a good sign for investors.

Beta and CAPM 

The significance of Beta becomes clear when understanding the foundational financial models such as CAPM. Beta is a significant component in CAPM (Capital Asset Pricing Model)

This model is the framework for calculating the expected return of an asset by analyzing the relationship between Beta, risk, market return, and asset return. The formula is below, 

E[ri]=rf+Bi(E(rm)-rf)

Beta is a major part of the critical financial metric. It plays a role in estimating the expected return of an asset based on it’s volatility/sensitivity in the market. (Don’t forget, it plays a significant role in a major strategy seen in investment portfolios.)

Everything Comes Together 

Typically in the financing world, if it’s too easy you are probably doing it wrong. For smart Beta investing, you need to evaluate all the connections and relationships. 

The three significant relationships are:

Utilizing the knowledge to combine the three above concepts will allow you to make senior-level decisions. You can clearly see an asset’s returns and risks when applying them. Luckily for you, Equities Lab calculates Beta and Alpha while you just have to create the stock screener. 

Keep up with our content to find more ways to use Beta to invest smarter! 

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