EstimatingBeta

Betameasuresthesensitivityofthereturnonthestocktovariationsinthemarketreturn.Itis
usuallyestimatedbyananalysisofthepastrelationshipbetweenthereturnofthestockandthatof
themarket.Thisinvolvescollectingasampleofpastreturnsonboththestockandthemarketand
estimatingthelineofbestfitbetweenthetwosetsofreturns.Thebeta(ormorestrictly,the
estimatedbeta)istheslopeofthisregressionline.

Theslopeofthelineisequaltothecovariancebetweenthestockreturnsandthemarketreturns
dividedbythevarianceofthemarketreturns.Youcanalsothinkofitasthecorrelationbetweenthe
twosetsofreturnsmultipliedbytheratioofthestandarddeviationofthestockreturnstothe
standarddeviationofthemarketreturns.Otherthingsequal,themorehighlythestockandmarket
arecorrelated,thehigherthebeta,andthemorevariablethestockisrelativetothemarket,the
higherthebeta.

AsimplewaytoestimatebetaistoenterthereturnsintoanExcelspreadsheetandusetheSLOPE
functiontoestimatebeta.Inthefollowingsimpleexampleyoushouldgetanestimatedbetaof
.786:

StockMarketReturnReturn
May4.06.1
June5.35.7
July2.43.0
=SLOPE(B3:B5,C3:C5)

Rememberthattheyvariableintheregressionisthesetofstockreturns,andthexvariableisthe
setofmarketreturns.Youwillgetdifferentandwrongestimatesifyoureversethetwoseries.

AWarning
Yousometimescomeacrosspeoplewhotrytoestimatebetabyregressingthestockpricesonlevels
ofthemarketindex.Thisgivesnonsenseresults.Youneedtoregressstockreturnsonmarket
returns.

Returns,PriceChanges,orRiskPremia
Oftendividendsarenotreadilyavailableanditissimplertomeasurepercentagepricechangesthan
returns.Inpracticedividendsvarysolittlecomparedwithpricesthatthismakesverylittledifference
toyourestimateofbeta(thoughitmayaffecttheestimatedalphaorintercept).

Anothercommonpracticeistoworkwiththedifferencebetweenthereturnsandtheriskfree
interestrate(i.e.,theriskpremium).Againtheriskfreeinterestratevariessolittlecomparedwith
stockreturnsthattheestimatedbetaisgenerallyverysimilar.However,itwillagainaffectyour
estimateandinterpretationoftheintercept.

Outliers
Thepossibilityoferrorsinestimatedbetasislikelytobelargerwhenthereareoutliersinthereturns
data.Forexample,onOctober19,1987theStandard&PoorsIndexdeclinedbynearly21%ina
singleday.Subsequentestimatesofbetausingdailyorweeklydatafromthatperiodwouldhave
beenheavilydependentonhowparticularstocksmovedonthatoneday.Whenthereisanunusual
movementinthestockpriceorinthemarketindex,itmaybehelpfultoomitthatobservation.

MeasuringtheMarket
Generallythemarketindexshouldincludeallstocksinthemarketweightedbytheirmarket
capitalization.Inpractice,itisoftenmoreconvenienttouseawellknownindexsuchasthe
Standard&PoorsComposite,andthismayevenproducebetterestimatesifthepricesofthe
omittedsmallercompanystocksareunreliable(seecommentsonthintradingbelow).

TimePeriod
Youneedalotofobservationstomakesurethatyourestimateofbetaisnotaffectedbychance
patternsinthereturns.Inpractice,therefore,togetareasonableestimateofbetayouneedfarmore
thanthethreeobservationsthatweusedabove.Onewaytoachievealargesampleistogobackin
time,butinthiscaseyouruntheriskthatthetruerelationshipbetweenstockandmarketmayhave
changed.Thealternativeistomeasurereturnsmorefrequently.Forlarge,frequentlytradedstocks
thereisnoprobleminusingweeklydata,butforsmallilliquidstocksusingshortertimeintervals
bringswithitathintradingproblem.Thisoccurswhenthereturnsonthestockandthemarketare
notperfectlysynchronized(e.g.,thelasttradeoccursatdifferentpointsintheday).Theeffectofsuch

thintradingistounderestimatethetruebeta.1
Thissuggeststhatthechoiceoftimeperiodinvolvesatradeoff.Wherethesampleincludesilliquid
stocks,itmaymakesensetouseupto5yearsofmonthlydata.Wherethesampleconsistsof

largecompanystocks,theremaybeanadvantagetousingacoupleyearsofdailyorweeklydata.2

Betaservicesusedifferenttimeintervals.Forexample,Yahoo!usesthreeyearsofmonthlyreturns,
whereasBloombergusestwoyearsofweeklyreturns.

AdjustedBetas

Calculatedbetasaresimplyestimates.Ifgoodcompanynewshappenstocomeoutonadaywhen
themarketrises,thenyouwillgetamisleadingimpressionoftheeffectofthemarketonthestock
price.Ifyourestimatedbetaisveryhigh,thenthereisagoodchancethatyouhaveanoverestimate
andthatthetruebetaislower.Conversely,iftheestimatedbetaisverylow,thenitisoddsonthat
youhaveunderestimatedthetruebeta.

Yourbestestimateofbetaisthereforecloserto1.0thantherawbetathatcomesoutofthe
regression.Therefore,estimatesofbetasometimesincludeanadjustmentthatpushesthebeta
towards1.0.Yahoo!doesnotmakeanyadjustment,butBloombergprovidesanadjustedbetathatis
(.67xrawbeta)+(.33x1.0).Thebetasthatwereportareallraw(unadjusted)betas.

Adjustmentstotherawbetausuallytakeoneoftwoforms.Intheonecase,rawbetasareestimated
forsuccessiveperiodsandthebetasinthesecondperiodareregressedonthoseinthefirstto
measurehowfarbetasshouldbepushedbacktotheaverageof1.0.Intheothercase,thesizeof
theadjustmentdependsonthestandarderrorofthebeta,sothatalargeradjustmentismadeto
rawbetasthathavealargepotentialerror.Theadjustedbetaisaweightedaverageoftherawbeta
andtheaveragebetaof1.0:
Adjusted=wraw+(1w)1.0

1
2

Theinclusionofthesestocksinthemarketindexwillalsoleadtoanoverestimateofthebetaofthemoreliquidstocks.

Forthinlytradedstocksfrequentdatainvolveanumberofproblemsinadditiontothintrading.Forexample,the

differencebetweenbidandaskpricesmaybelargeforilliquidstockandthebouncebetweenbidandaskcanberelatively
largewhenlookingatdailyprices.

Wherew=se2/(se2+2)seisthestandarderroroftheestimatedbeta,and2istheestimated
crosssectionalvarianceofthebetasofstocksintheindex.3

Note,thisisusuallymeasuredasthecrosssectionalvarianceoftheestimatedbetaslesstheaveragesquaredstandard
erroroftheestimatedbetas.