Sometimes people get confused between beta and volatility because both are measures of risk. So you might see a firm like McDonald’s having a beta of 0.7 and a volatility of 1.05 and then see another firm like Amazon having a higher beta and yet a lower volatility. And that might be confusing if you’re just kind of seeing beta and volatility both as measures of risk and not really understanding the difference between the two.
And so remember that volatility is the standard deviation of a stock’s return. So, ultimately that’s a measure of total risk of the firm. So when we think about the volatility of McDonald’s let’s say being 1.05, that’s really the total risk of Mcdonalds’, and what beta is measuring is the market risk of McDonalds. So this 0.7 is telling us the percentage increase or change in Mcdonald’s stock return given a 1% change in the return of the market portfolio. So that’s the systematic or market risk of Mcdonald’s, the part that cannot be diversified away. So this is Mcdonald’s relationship to the overall market – that’s what beta captures, the systemic risk.
Volatility is capturing not just that market risk that’s measured by beta but also firm-specific risk. So, that’s just the risk that can be diversified away in a large portfolio. When we see the Amazon has a higher beta and yet a lower volatility what this essentially means is that Amazon has more market risk, so if the market goes up Amazon’s gonna go up even further. It is going to go up 1.46% given a 1% increase in the market, and conversely the market goes down 1% Amazon’s gonna go down 1.46%. So it’s like its effect-the effect on Amazon’s return of the market is amplified. It’s even larger than what the market return is.
McDonald’s don’t have as much market risk and actually they’re much less not just than Amazon but even less than the average firms in the market. The average firms gonna have a beta of 1 and McDonald’s is less than that. And that makes sense – they sell food even if the market is doing poorly. People still need to buy food. You see the higher volatility than Amazon and you might be trying to reconcile that. Because we see that McDonald’s has lower market risk (because it has a lower beta than Amazon) if its volatility is higher than Amazon’s that it has higher firm specific risk. So then if you see something like this and you’re wondering how to interpret it, it would mean that the firm that has the higher volatility and yet the lower beta they actually have higher firm specific risk, and that might be caused by something, like perhaps, McDonald’s just fired their CEO and they’ve been having all kinds of problems. The stock has been going up and down people have no idea what’s going to happen the firm. There’s a lot of risk specific to McDonalds that really doesn’t have anything to do with the overall market.