Week 40 Day 5: Beta: How Much Your Portfolio Moves With the Market

If the market drops 10%: a beta-1.0 stock drops approximately 10%. A beta-1.5 stock drops approximately 15%. A beta-0.5 stock drops approximately 5%. Bonds (beta approximately 0) barely move. When you combine stocks and bonds, you are blending high-beta (stocks) with low-beta (bonds) to get a portfolio beta that matches your risk tolerance.

Beta values of common investments: VTI: 1.0 (by definition -- it IS the market). SCHD: approximately 0.8 (less volatile than the overall market; dividend stocks tend to be more stable). Growth stocks (VUG): approximately 1.1-1.2 (more volatile, more sensitive to market swings). Small-cap stocks: approximately 1.2-1.5 (higher beta, higher expected returns). Intermediate bonds (VCIT): approximately 0.0-0.2 (very low market sensitivity). Gold (GLD): approximately 0.0-0.1 (uncorrelated with stocks). Bitcoin: approximately 1.5-2.5 (more volatile than the stock market). Uses of beta: (1) Portfolio overall beta = weighted average of component betas. An 80/20 VTI/BND portfolio: beta = (0.8 * 1.0) + (0.2 * 0.0) = 0.8. Expected to decline approximately 80% as much as the overall market during a crash. (2) Stress testing: if the market drops 30%, your beta-0.8 portfolio drops approximately 24%. Can you handle that? If not, add more bonds (reduce beta further). (3) Understanding performance. If the market returned 15% and your portfolio returned 12%, was that underperformance? If your portfolio beta is 0.8, then expected return was 0.8 * 15% = 12%. You performed exactly as expected. No underperformance at all -- just lower beta. Limitations: beta only measures sensitivity to the overall MARKET. It does not capture sector-specific risk, interest rate risk, or idiosyncratic (company-specific) risk. A stock can have beta of 1.0 and still crash 90% due to company-specific problems.

Beta is the central concept of the Capital Asset Pricing Model (CAPM, Sharpe 1964, Lintner 1965, Mossin 1966): E[R_i] = R_f + beta_i * (E[R_m] - R_f), where R_f is the risk-free rate, R_m is the market return, and beta_i = Cov(R_i, R_m) / Var(R_m). Under CAPM, beta is the ONLY risk factor that earns a premium: idiosyncratic risk is diversifiable and therefore uncompensated. The empirical performance of CAPM is mixed: Fama and French (1992) showed that beta alone does not fully explain cross-sectional returns and that book-to-market (value) and size factors add explanatory power, leading to the Fama-French three-factor model (and later the five-factor model, 2015). Despite CAPM's limitations as a pricing model, beta remains useful as a portfolio management tool: it decomposes portfolio return into market-driven (beta * market return) and non-market-driven (alpha = actual return - beta * market return) components. For index investors, beta is largely irrelevant for stock selection (VTI owns everything) but essential for asset allocation: the portfolio's overall beta determines its expected return and volatility relative to a 100%-equity benchmark. Reducing beta from 1.0 to 0.8 (by adding 20% bonds) reduces expected return by approximately 1.5% but reduces expected drawdown by approximately 10 percentage points -- a tradeoff that is welfare-improving for loss-averse investors.