Return-Generating Models: The market Model Beta

R_i = alpha_i + beta_i * R_m + e_i

where the R_m is the return of the market. You can simply get the monthly return for a given stock and the S&P 500 as the market. Run a linear regression and the slope will be your beta.


Based on this post from Quantitative Finance from Stackexchange, the Beta calculated was based on the monthly return for the past three years. Comparing with our calculation in Python, the number lines up pretty well.

Note: I was using the close price, when using the open price, it was pretty close too. However, the beta calculated using high and low is pretty different from Yahoo Finance.



Portfolio Risk – Diversification and Correlation

This article is a visualization of a portfolio of two assets where we see how portfolio return and risk changes as the weight changes and the correlation between the two underlying assets changes.


This is a very typical risk return plot where the horizontal axis represent the risk – standard deviation of the portfolio where the vertical axis represent the expected return of the portfolio. All the data points are color coded by the correlation between the two assets (eg. purple +1, 100% positive correlated). It might not be that obvious, but I set the size of each data point to be the weight for asset 1 where the biggest represent all the capital is allocated to the asset one, and vice versa.

Here is a screenshot of the R code to generate the graph above.


The key takeaway is that given same expected return, you want to diversify your portfolio in a way where underlying assets are more negatively correlated to each other to reduce the risk. This might sounds magical but the math did serve the purpose of proof. However, it is easier to say than doing, if you have an asset that has a good return, but might correlate positively which you will like to replace, in real life, it will be hard to find some alternative with the same return because if a stock is negatively correlated to what you already have, it probably has a subpar return rate (hedging is another thing if that is what you want to achieve).