Portfolio Beta Explained: Balancing Risk and Return

7 min read

Too many investors focus solely on making money rather than protecting what they already have.

When Paul Tudor Jones shares this advice, you better believe, I listen. Prioritizing risk management is, in my opinion, the smartest way to begin any investment journey. There are countless strategies to safeguard your portfolio, from diversification to disciplined monitoring. Until the government takes meaningful steps to discourage overconsumption and promote saving and investment, I will continue to focus on preserving my assets while pursuing steady, risk-adjusted growth.

A key element of effective investing is understanding the metrics that influence performance, and one I like to use is portfolio beta. Beta measures a stock's volatility relative to the market, providing insight into whether the potential returns justify the risk. Using the S&P 500 as a benchmark (beta = 1), stocks with betas greater than 1 tend to experience larger price swings, while those with betas below 1 are typically more stable.

To illustrate, consider a tech stock with a beta of 2.55 and a year-to-date return of 37%. At first glance, the return seems impressive. However, the high beta indicates significantly greater volatility compared to the broader market, where the S&P 500 has a 26% YTD return and a beta of 1. This raises a critical question: Is the risk-adjusted return of the tech stock worth the added volatility?

Risk-Adjusted Return: The Role of Volatility

To evaluate risk-adjusted performance, investors can calculate the return-to-beta ratio, which indicates how much return is achieved per unit of market risk:

- S&P 500 26% ÷ 1.00 ≈ 26% risk-adjusted return.

- NASDAQ 27.9% ÷ 1.11 ≈ 25.135% risk-adjusted return.

- Tech Stock 37% ÷ 2.55 ≈ 14.51% risk-adjusted return.

This shows that, while the tech stock offers higher raw returns, its volatility reduces the appeal to a risk-conscious investor. A sudden market drop could result in larger losses for the tech stock than for the S&P 500. For instance, if the S&P 500 fell 10%, the tech stock could theoretically drop by 25.5%. For many, this signifies underperformance given the level of risk. For others, it might still be a justified addition depending on the portfolio context and individual risk tolerance. The decision lies in the investor's goals, strategy, and risk appetite. But at this point in time, it would not be an investment to brag about.

Retail Investors and Beta

For retail investors starting out, wealth preservation should take priority. Allocating to low-beta investments like the S&P 500, ensures a foundation of stability. Setting a target, such as accumulating $50,000 or $100,000, before venturing into higher-beta stocks is a prudent strategy.

While beta is useful for gauging volatility, it is by far not the sole factor for investment decisions. Retail investors should balance beta with considerations like growth potential, cash flow, and market conditions. Institutions, with diversified portfolios, can manage high-beta risks better, but individuals are better served by viewing beta as one tool among many to achieve their financial goals.

Calculating Portfolio Beta: Simplified

For those managing diversified investments, calculating the beta of a portfolio can provide insights into overall risk. Portfolio beta is a weighted average of the betas of individual holdings. Here's a simplified formula:

Portfolio Beta = sum of Weight of Stock times Stock Beta. For example, if your portfolio consists of:

50% in the S&P 500 (Beta = 1) | 30% in a tech stock (Beta = 2.183) | 20% in bonds (Beta ≈ 0.3)**

Your portfolio beta would be = (0.5 times 1) + (0.3 times 2.183) + (0.2 times 0.3) = 1.215

This shows your portfolio is about 21.5% more volatile than the market. Theoretically, if you’re portfolio, on average, is not able to earn 31.59% (representing the S&P 25.99% return, times the portfolio beta of 1.215) it may be time to perform some rebalancing and/or reallocation.

Why Portfolio Beta Matters

Understanding portfolio beta can guide decisions on asset allocation. Investors seeking stability may prefer portfolios with a beta below 1, while those willing to accept more risk for higher returns might target portfolios with a beta slightly above 1.

Diversification plays a crucial role in managing portfolio beta. For example, exchange-traded funds (ETFs) provide an efficient way to diversify, as they offer exposure to a basket of assets within a single investment. ETFs tracking broad indexes like the S&P 500 typically have a beta close to 1, balancing risk and return for those seeking a stable portfolio foundation.

A well-diversified portfolio ensures that no single asset disproportionately impacts the overall risk, making it easier to align portfolio beta with your financial goals and risk tolerance.

Beta's Limitations for Retail Investors

While beta measures volatility, it doesn’t account for factors like dividends, company fundamentals, or market trends. Therefore, retail investors should combine beta analysis with other metrics like:

Alpha: Measures performance relative to a benchmark, independent of risk.

Sharpe Ratio: Evaluates returns relative to total risk, not just volatility.

Beta is most effective when paired with a clear understanding of investment goals and time horizon.

Improving Risk-Adjusted Return Awareness

Consider hypothetical scenarios to demonstrate volatility’s impact:

- If a high-beta stock returns 37% one year but drops 40% the next, it takes a 66.7% gain just to break even.

- Conversely, a stable portfolio growing at 8% annually offers steadier compounding over time, minimizing losses.

By balancing risk with return potential, retail investors can avoid pitfalls associated with high-volatility stocks. Starting with low-beta investments ensures a strong foundation, creating space to explore higher-beta assets as wealth and confidence grow.

For retail investors, understanding where the economy is in the business cycle can enhance decision-making about portfolio beta. In expansionary periods, higher-beta stocks may capture larger gains, while during economic downturns, lower-beta investments offer stability. By combining insights from market indicators, historical performance trends, and personal risk tolerance, retail investors can better align their portfolios with their financial goals. Again, while beta is not the sole determinant, recognizing its interplay with economic cycles equips investors to optimize risk-adjusted returns over the long term.

Understanding beta is just the start; professional guidance from companies like, BMG can help tailor your portfolio to your goals. Let us help you uncover your current level of risk of within your investment portfolio and assess its performance on a risk-adjusted basis. Are you confident your investments are delivering the returns you deserve given your level of risk? Contact us today to find out!