When you invest money, be prepared to encounter bumps along the way. The cryptocurrency and other financial markets move up and down all the time, but the individual assets that comprise the market all move at different paces. Some might have higher highs and lower lows, and others might move in nearly identical fashion to the market as a whole.
Will an asset feel like a roller-coaster ride? Or will it feel more like you’re driving on a highway at the same pace as the car next to you? Its beta can offer helpful cues but first, we have to understand beta meaning in finance and how to calculate beta.
Beta Meaning In Finance
In finance, a beta coefficient is a tool used to measure the volatility of a certain asset in relation to the volatility of the overall market or a particular portfolio. In other terms, beta can be used to assess the risk of an investment in correlation to a benchmark, which can be represented by a broad market index or by a specific portfolio.
For instance, beta can be used to calculate an asset’s expected return on investment, according to its volatility in relation to the market. As such, beta is not used to measure the risk of investing in a particular asset alone. Instead, it measures the amount of risk that the investment would add to an existing portfolio.
How Beta Coefficient Works
If we consider all investable assets in existence, we would be comparing the whole market against itself, meaning that the value of beta would be precisely 1. But when comparing a certain financial instrument against the market, we will most likely get a beta higher or lower than 1. A beta higher than 1 indicates that the asset is not only volatile but also highly correlated with the market. In contrast, low or negative values of beta may suggest that an investment has lower volatility than the market, or that its price movements aren’t highly correlated with the market.
However, the beta coefficient may be deployed differently depending on the context. For example, mutual funds may calculate the beta coefficient of a financial instrument to gather insights into the risks of adding it to their investment portfolio. So beta calculations can help them choose which assets to include in their holdings, according to their risk profile.
If we apply the concept of the beta coefficient to cryptocurrency markets, Bitcoin could be used as the benchmark. So one could calculate the beta for KAN or other altcoins in relation to Bitcoin’s price and volatility. Alternatively, Bitcoin’s volatility could be measured against gold or stock markets. The resulting beta would give insights into the correlation between Bitcoin and traditional financial markets.
How to Calculate Beta
An asset's beta is calculated by dividing the product of the covariance of the asset's returns and the market's returns by the variance of the market's returns over a specified period. The Calculation for Beta Is As Follows:
Beta Coefficient (β) = Covariance (Re , Rm) / Variance (Rm)
where:
Re = the return on an individual asset
Rm = the return on the overall market
Covariance = how changes in an asset’s returns are related to changes in the market’s returns
Variance = how far the market’s data points spread out from their average value
The beta calculation is used to help investors understand whETHer an asset moves in the same direction as the rest of the market. It also provides insights into how volatile – or how risky – an asset is relative to the rest of the market. For beta to provide any useful insight, the market that is used as a benchmark should be related to the asset. For example, calculating a bond ETF's beta using the S&P 500 as the benchmark would not provide much helpful insight for an investor because bonds and stocks are too dissimilar
Drawbacks To Beta Coefficient
While beta can offer some useful information when evaluating an asset such as determining its short term risks, it does have some limitations. Since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict an asset's future movements.
Beta is also less useful for long-term investments since an asset’s volatility can change significantly from year to year, depending upon the project's growth stage and other factors. Furthermore, the beta measure on a particular asset tends to jump around over time, which makes it unreliable as a stable measure.
Closing Thoughts
Predicting how much an investment or your entire portfolio may move when the market is up or down can be an important component of investing. If you don't want to experience big swings, you could look for options that have a low beta. Or, hedge against high beta investments with investments that have a negative beta. If you're not as risk averse, you could look for options with a higher beta that could lead to larger returns.
But be careful, a high beta can also mean bigger losses. Also, remember that beta doesn't measure factors that may be specific to a single company or asset. It can be helpful in building your portfolio, but you want to consider beta within a larger context and only as one piece of analysis. Having learnt how to calculate beta through a beta calculation example would surely help your investment decisions from now on!
