Figure 3-9 graphs the relative volatility of three stocks. The data below the graph
assume that in 2000 the “market,” defined as a portfolio consisting of all stocks, had a
total return (dividend yield plus capital gains yield) of M10%, and Stocks H, A, and
L (for High, Average, and Low risk) also all had returns of 10 percent. In 2001, the
market went up sharply, and the return on the market portfolio was M20%. Returns
on the three stocks also went up: H soared to 30 percent; A went up to 20 percent, the
same as the market; and L only went up to 15 percent. Now suppose the market
dropped in 2002, and the market return was M10%. The three stocks’ returns also
fell, H plunging to 30 percent, A falling to 10 percent, and L going down to L
0%. Thus, the three stocks all moved in the same direction as the market, but H was by
far the most volatile; A was just as volatile as the market; and L was less volatile.
Beta measures a stock’s volatility relative to an average stock, which by definition has
b 1.0. As we noted above, a stock’s beta can be calculated by plotting a line like those
r
r
r
r
124 CHAPTER 3 Risk and Return
FIGURE 3-9 Relative Volatility of Stocks H, A, and L
Year HA LM
2000 10% 10% 10% 10%
2001 30 20 15 20
2002 (30) (10) 0 (10)
Note: These three stocks plot exactly on their regression lines. This indicates that they are exposed only to market
risk. Mutual funds that concentrate on stocks with betas of 2, 1, and 0.5 would have patterns similar to those shown
in the graph.
r r r r
Return on Stock i, r
(%)
30
20
10
–10
–20
–30
–20 –10 0 10 20 30
X
Stock H,
High Risk: b = 2.0
Stock A,
Average Risk: b = 1.0
Stock L,
Low Risk: b = 0.5
Return on the Market, rM (%)
i
_
_
122 Risk and Return
