Beta is a measure of market risk. If the beta of a stock is more than 1, it means stock moves along with the market in the same direction and is more volatile than the market. If the beta is less than 1, it means that stock is less volatile and not related to the market. Read more about beta here.
Similar to stock beta, a portfolio beta represents the volatility of the portfolio. In one of the earlier chapters we understood the benefit of diversification and how it allows us to protect ourselves against company/sector specific risk. However market risk – risk that is not specific to any single company and affects all the companies in the market – is not diversifiable. A portfolio beta represents market risk.
Portfolio beta helps us understand the direction of the portfolio movement and the strength of the portfolio movement in comparison to the market
If the beta of the portfolio is more than 1, it means that the portfolio moves in the same direction as the market and at a faster pace than the market. Similarly if beta is less than 1 it means portfolio does not move in tandem with the market. So let’s assume imaginary portfolio X has a beta of 1.3. Suppose the market is expected to increase by 1% on a particular day, portfolio X can be expected to increase by 1.3% (1% * 1.3). Similarly if imaginary portfolio Y has a beta of -0.8, then on a day market is expected to increase by 1%, portfolio Y can be expected to decrease by 0.8% (1% * -0.8).
Portfolio beta is the weighted average beta’s of the individual stocks of the portfolio. Proportion of company’s weight in the portfolio can be used as the weight when calculating portfolio beta. So portfolio beta can be altered by changing stocks in the portfolio. If the investor expects the market to go up over the next 1 year, then he can add high beta companies to his portfolio to enhance portfolio returns. On the contrary if the markets are expected to drop over the next 1 year, the investor can load up his portfolio with low/ negative beta stocks thereby protecting portfolio returns.