If you buy any asset, you get the asset and a risk. If you want to evaluate this risk you need a risk measurement tool. A widely used tool to compare risk in financial markets is the BETA-factor. This article explains the construction of this risk coefficient, its use and limitations.

Anchor Points for BETA
The risk involved in holding an asset comes from the fact that asset prices fluctuate, they go up and down. The BETA-factor does not talk about absolute price changes of an asset. It measures the price changes of this asset in comparison with the overall asset market. Financial professionals use as a proxy for the overall asset market. This works under normal circumstances quite well, but there remain some reservations related to this approach when major components of the asset markets like the real estate market or sovereign bond markets experience major disturbances.

This risk measurement tool allows us to quantify the relative risk of an asset compared to another asset.
In practice the S&P index is often set as BETA 1, while cash does not change its nominal value and thus posts a BETA 0.

A negative BETA would be an asset with a negative correlation to the overall asset markets. This could be shares of a company making money by sorting out bankruptcies, but the sector making more money when everybody else is in trouble must be very tiny. If the BETA-factor is too high e.g. 20, the underlying business would not be sustainable and loose all its value if the general markets decline just by 5 percent. So for all practical purposes BETA is seen as a positive number in the single digits.

Limitations
This risk measurement concept has, with all its practicality, also some shortcomings. If you want to use this Concept in your risk management you need to understand the following fact:

• The BETA-Coefficient for each asset is calculated from historical data with regression analysis. This means that the number shows us what happened in the past. But things may change, and a reasonable history is not a guarantee for the future. A business could take a load of new debt to finance a new uncertain project. It would now be much more risky.
• The risk position of a whole sector may change for political or technological reasons.
  Compared to the energy sector which depends much on the overall economic activity, the agricultural sector has a quite stable demand picture. But nowadays we observe that fossil energy reaches at times a price level high enough to substitute petrol with agricultural commodities. This changes certainly the risk behavior of agricultural assets.
• Another problem for risk measurement with the BETA-Factor is hidden in the tail risk. As long as the overall market remains inside the usual ranges, the relationship between the risks of two assets or asset classes may be reasonably linear. But come unexpected circumstance, assets considered conservative and low risk (e.g. public debt instruments) may turn out to be high risk, no longer hold by pension funds but traded by hedge funds.

Conclusion
The BETA factor as risk measurement tool is very useful to manage your portfolio. Using them you need to cover your exposure to extreme market changes by setting automatic stop losses and using spreads whenever trading derivates. And you have to reevaluate and rebalance your portfolio in relatively short time intervals.

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