PART 2: VALUATION, RISK AND RETURNand the return on the S&P/ASX 200 in a particular month. Through each scatter plot we have drawn
a trend line, estimated by using the method of linear regression. This trend line shows the average
tendency for each share to move with the market. However, clearly OrotonGroup shares do not track
the market perfectly, which is evidence that there are unsystematic risks that affect OrotonGroup
share returns.
These two shares respond differently, on average, to market movements. The OrotonGroup’s
trend line slope equals 1.4. Thus, on average, if the market’s return one month moves by 1%, then
the return on OrotonGroup shares moves in the same direction by 1.4%. AGL Energy shares behave
quite differently, displaying a much lower tendency to move in conjunction with the market. With a
gradient of 0.4, AGL Energy’s trend line tells us that if the market return moves up or down 1%, on
average, AGL Energy’s return moves just 0.4% in response. These differences in responsiveness lead
to an important conclusion. Because returns on OrotonGroup are more sensitive to overall market
movements, OrotonGroup ordinary shares have more systematic risk than AGL Energy shares. In
other words, when a macroeconomic event, such as an unexpected shift in interest rates, moves
the entire market, OrotonGroup shares typically respond more sharply than do AGL Energy shares.
These results make sense when we consider the businesses each company is engaged in. AGL
Energy provides energy to consumers. The demand for this is quite inelastic – energy is required
whether or not the market is doing well. In contrast, the demand for luxury goods is likely to be very
elastic; when consumers feel wealthier – for example, if their equity investments are performing
well in a bull market – they are more likely to choose to purchase luxury items than if they are
feeling less wealthy.
The slopes of the trend lines in Figures 7.2a and 7.2b have a special designation in finance,
known as beta. A share’s beta measures the sensitivity of its return to movements in the overall
market return. Thus, beta is a measure of systematic risk. The return on a high-beta share like
OrotonGroup typically experiences dramatic up-and-down swings when the market return moves.
Because OrotonGroup’s beta equals 1.4, we can say that the return on OrotonGroup’s shares
moves, on average, 1.4 times as much as does the market return. In contrast, with a beta of just
0.4, the return on AGL Energy share moves much less on average when the overall share market
fluctuates. This is not the same thing as saying that AGL Energy is not a volatile share. The individual
dots in Figure 7.2b show that monthly returns on AGL Energy usually fall in a range between
positive and negative 15%. Clearly, a share that can gain or lose 15% in a month is volatile, but AGL
Energy’s return does not move sharply in the same direction as the overall market return. Hence, the
systematic risk of AGL Energy is relatively low.
Finally, look at Figure 7.2c, which plots monthly returns produced by a portfolio invested
equally in OrotonGroup and AGL Energy. Two important points emerge from this figure. First,
notice that the slope of the line, which is the beta of the portfolio, is 0.9. That is actually equal to
the average of the betas of OrotonGroup (1.4) and AGL Energy (0.4). In other words, the beta of a
portfolio is a weighted average of the betas of the shares in the portfolio. Second, observe how in Figure
7.2c the dots cluster a little closer to the trend line than they do in Figures 7.2a and 7.2b. This
occurs because in the portfolio, some of the unsystematic risk of the individual shares has been
diversified away.beta
A standardised measure of the
risk of an individual asset that
captures only the systematic
component of its volatility; it
measures the sensitivity of the
asset’s return to movements in
the overall market