Question

Explain the differences in ranking stocks according to the standard deviation (SD) and beta. This should entail explaining the different aspects that SD and beta measure, and why a stock that has the highest standard deviation might not have the highest beta.

Answer 1

Every stock consists of two types of risk -systematic risk and unsystematic risk. The systematic risk is measured by the Beta of the stock. The systematic risk or Beta specific to a stock is basically the risk which depends on the market and cannot be diversified. The market has a Beta value of 1.So if a stock has a Beta value of more than 1, then it is a riskier stock than the market in terms of systematic risk. The beta values of a stock changes with respect to the market and economic conditions. So ranking a stock on the basis of Beta value will capture only the undiversifiable risk and not take into account the total risk. Beta is more of a current measure of a stock.

On the other hand standard deviation tells the total volatility of a stock, mainly based on past returns. The standard deviation takes into account both the systematic and unsystematic risk, that is the total risk. So if a stock has high standard deviation, it may be due to high beta value or high value of unsystematic/ diversifiable risk. So a high standard deviation does not necessarily mean high beta. However Beta is a more important measure of risk because we can somehow eliminate the unsystematic risk by proper diversification, but we can't eliminate the market risk or beta risk of a stock.