# 7-4 How Individual Insecurities Affect Portfolio Risk

Remember

*The risk of a well-diversified portfolio depens on the market risk of the securities included in the portfolio.*

## 🅱️ Market Risk Is Measured by Beta

It is not a good practice to measure risky a security is if held in isolation. You need to measure its *market risk*. You do this by measuring how sensitive it is to market movements. This sensitivity is called **beta **.

**Beta > 1.0**-> amplify the overall movements of the market**0 < beta < 1.0**-> move in the same direction as the market, but not as far.

The market is the portfolio of all stocks, so the "*average*" stock has beta = 1.0

Many of the stocks with high standard deviations also have high betas, but this is not always the case.

## ⁉️ Why Security Betas Determince Portfolio Risk

Review

- Market risk accounts for most of the risk of a well-diversified portfolio.
- The beta of an individual security measures its sensitivity to market movements.

### In a portfolio context, a security's risk is measured by beta.

Better diversification makes the portfolio risk declines untill all specific risk is eliminated and only the *bedrock* of market risk remains.

The bedrock depends on the average beta of the securities selected.

Portfolio beta 1.0

- portfolio containg 500 stocks drawn randomly from the market
- results in a portfolio
**very**similar to the whole market. So beta is 1.0

- results in a portfolio
- standard deviation of the market is 20%
- so portfolio standard deviation is 1.0 x 20% = 20%

Portfolio beta 1.5

- portfolio containing 500 stocks with virtually no specific risk
- beta of the portfolio is 1.5

- standard deviation of the market is 20%
- so portfolio standard deviation is 1.5 x 20% = 30%
- portfolio will amplify every market move by 50%
- portfolio with 150% of the market's risk

**Calculating Beta**

Beta of stock i

= covariance between stock returns and market returns is variance of the return on the market