Using the Systematic Risk Principle & Portfolio Beta

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  • 0:04 Understanding Systematic Risk
  • 1:23 Portfolio Beta
  • 3:18 Lesson Summary
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Lesson Transcript
Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson, we'll discuss how investors must understand the systematic risk principle in their portfolio. We'll also explain how investors can measure and define the risk of their portfolios using betas.

Understanding Systematic Risk

James is taking a greater interest in exploring the risks of his stock market portfolio as he becomes more educated about investing. One fact of investing that is critical for James to understand is that investing always and fundamentally involves risk. Let's help James understand how systemic risk affects his portfolio, as well as how the concept of betas can be used to interpret risk.

Every investment carries risk. There is always the possibility that an individual company stock could plummet to zero, and events like the Great Depression and the recession of 2008 affect the entire market. Systematic risk is the principle that some risks are unavoidable and that diversification cannot prevent risk. Up or down swings in the market, known as volatility, are ultimately unpredictable.

While eliminating risk is impossible, James helps compensate for systemic risk. By putting his investments into different classes of investment products, he can reduce the overall volatility of his portfolio. For example, when stocks are down in value, bonds might remain up, or at least not drop in value as much. Multiple asset classes can help smooth out the effects of volatility, and thus reduce the risk of a dramatic swing in overall portfolio value.

Portfolio Beta

To figure out exactly how much risk his portfolio has taken on, James can use the concept of betas. In investing terminology, beta refers to an investment's risk in relation to a specific benchmark, and it's expressed as a number. The S&P 500 index, which tracks the value of the largest 500 companies in the United States, is a common benchmark, although other investments can be selected.

Let's assume that James is using the S&P 500 benchmark. If the S&P 500 rises 15% and one of James' stocks also rises 15%, the beta is 1. If James's stock were to rise 30%, or twice the rate of the S&P 500, the beta is 2. On the other hand, a 7.5% increase in the share price would mean the beta is 0.5. The higher the number, the greater the rate of change in value for the investment when compared to the benchmark index.

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