Does the Equity Beta remain stable over time?

A number of studies using different techniques and different economies and time periods have found that equity betas are unstable in both individual common stock and portfolios.

Equity beta measures the volatility of a security relative to the market’s volatility. A security with a beta of 1.00 rises and falls at the same rate as a broad market index, for example S&P 500.

Finance theory ascertains that as individual stocks are aggregated into portfolios, the diversification effect must produce a beta for the portfolio that is relatively more stable since beta instability in the individual stocks is driven, at least in part, by microeconomic factors.

Despite this, studies show that a higher degree of beta instability in portfolios had taken shape from randomly chosen stocks, in comparison to the beta instability found in individual stocks.

This phenomenon can be attributed to a diminishing effect in background noise through portfolio formation making beta instability easier to detect, and hence, supervising the diversification effect. It is also possible that the increased beta instability occurred due to macroeconomic factors.

Time Scale Measurements to check beta instability

Time scales of measurement are rooted in the investment horizon of different classes of investors. Most of the financial markets are usually characterized by "heterogeneous investors", with various types of investment horizons.

  • There are intraday traders in the markets, who carry out stock trading only within a given trading day.

  • Also, there are market traders with relatively shorter or longer horizons of the market investment.

In accordance with their trading horizons, the behavior of different trading classes varies and may contain different risk perceptions.

Secondly, in heterogeneous markets, a low, frequent, or systematic shock to the system penetrates through all the layers.

  • A high-frequency shock is short-lived and may have no impact out of the immediate time span.

  • However, a systematic shock may have a long-lasting impact on the performance of the market.

The variance of responses to the different disturbances and the heterogeneous formation of the market is intimately related to the riskreturn trade-off which is central to the portfolio allocation and pricing patterns of different financial instruments.

Also, in emerging markets, conditions are very fluid; so the leading firm on a particular occasion may well be a follower on another day or viceversa. New firms are joining the market rapidly and even firms themselves are changing quite frequently. Companies are expanding into new markets, and at times coming up with different products. Therefore, an assumption that risk in holding a firm’s stock will be constant over a longer period, say in an emerging market economy, would be a restrictive assumption.