Beta vs. Standard Deviation: Risk in CAPM Explained

Imagine you’re deciding whether to invest in two different companies. Let’s say one is a well-established, steady utility company, and the other is a brand-new tech startup. Both investments carry risk, of course. The utility company might face regulatory changes, and the tech startup could fail to gain traction in the market.

Now, if you were to look at the overall risk of each investment, you might consider something called standard deviation. Standard deviation is like a measure of how much the price of an asset typically swings up and down over time. Think of it as the total ‘wobbliness’ of the stock price. A high standard deviation means the price is quite volatile, jumping around a lot, while a low standard deviation indicates a more stable price. This standard deviation, or total volatility, captures all sorts of risks – everything from company-specific problems to broader market fluctuations.

However, when we talk about the Capital Asset Pricing Model, or CAPM, and figuring out the expected return of an asset, we focus on a different kind of risk measure called beta. Beta is not about the total wobbliness of a stock. Instead, it’s about how much a stock’s price tends to move in relation to the overall market. It’s a measure of what we call systematic risk, or market risk.

To understand why beta is more relevant in CAPM, let’s think about diversification. Most investors don’t put all their eggs in one basket. They build a portfolio, holding a mix of different investments. By diversifying, you can significantly reduce some types of risk. Consider the tech startup again. If it fails, that’s bad news for your investment in that single company. But if you also hold investments in many other companies across different sectors, the failure of one startup will have a much smaller impact on your overall portfolio. This company-specific risk, the risk that is unique to a particular asset, is what we call unsystematic risk or diversifiable risk.

On the other hand, there are risks that affect the entire market. Think about something like a major economic recession, a global pandemic, or a significant change in interest rates. These events tend to impact most companies and assets to some degree. This is systematic risk, or non-diversifiable risk. No matter how diversified your portfolio is across different stocks, you can’t completely eliminate the impact of these broad market forces.

Beta specifically measures this systematic risk. A beta of 1 means that, on average, the stock price tends to move in the same direction and magnitude as the market. A beta greater than 1 suggests the stock is more volatile than the market, and its price tends to amplify market movements. A beta less than 1 implies the stock is less volatile than the market and its price movements are dampened compared to the market. A beta near zero suggests the stock’s price is largely independent of market movements.

Now, back to CAPM. The model is built on the idea that investors are only compensated for taking on risks they cannot diversify away. Rational investors can, and should, diversify their portfolios to eliminate unsystematic risk. Therefore, the only risk they should be rewarded for bearing is systematic risk, the risk that remains even in a well-diversified portfolio.

Since beta measures systematic risk, it becomes the relevant measure of risk in CAPM for determining expected return. The model essentially says that the expected return of an asset should be proportional to its beta. Assets with higher betas, meaning they contribute more systematic risk to a portfolio, should offer higher expected returns to compensate investors for bearing that unavoidable risk. Assets with lower betas, contributing less systematic risk, should offer lower expected returns.

In essence, while standard deviation tells us the total risk of an asset, beta tells us the asset’s contribution to the systematic risk of a diversified portfolio. And in the world of CAPM, it’s this systematic risk, captured by beta, that is the key driver of expected return. Investors are not rewarded for bearing diversifiable risks, only for the systematic risks they cannot escape.