Stock "beta" is a statistical measure that compares the volatility of returns on a specific stock to those of the market as a whole. It is an important indicator of the risk and opportunity of an individual stock and is widely used by investors. Learn more about what beta represents and how to use it.
Understanding ‘Beta’ For Stocks
Stocks all have a characteristic volatility that describes the up and down movements in the stock’s historical returns. Volatility is used to evaluate a stock’s risk and potential reward. It can change over time for each stock and will vary somewhat depending on the historical period it is calculated from, but one of the main determinants of a stock’s volatility is the nature of its business, as certain businesses are simply more stable over time, while others have greater up and down movements in their returns.
The overall market has volatility also, which we usually measure by using the volatility of the . Beta (or the ‘beta coefficient’) is essentially the comparison of the volatility in a particular stock to that of the market as a whole. We can think of it as the ratio of a stock’s movements relative to the market as shown in the table below.
Beta What It Means 1.0 The stock tends to move up or down about as much as the overall market (same direction) >1 The stock tends to move up or down by a greater percentage than the market (same direction) <1 The stock tends to move up or down by less than the market (same direction)
If a stock has a beta greater than 1.0, then its return movements are likely to be more volatile than those of the overall market.
Stocks are all assumed to carry two types of risk:
- Idiosyncratic risk
- Systematic (or market) risk
The good news about that is that idiosyncratic risk can be reduced through diversification. Thus, if you favor high-beta stocks, it might be wise to diversify your portfolio enough to lower the additional risk you are taking on.
Tip: Beta should not be confused with Alpha. Alpha measures outperformance after volatility has been considered. If a stock has a beta of say 1.5, when the market rises 6% that stock would on average move up by 9%. If that stock moves up 11%, it has achieved an alpha of 2%.
Statistical Definition of 'Beta'
Statistically, beta is calculated by dividing the covariance of a stock’s return relative to the market by the variance in the market’s return. The formula is illustrated by Business Insider below.
Graphical Illustration of 'Beta'
Beta can also be portrayed graphically as the slope of a graph of a stock's returns vs. the market's returns in the same period.
Evaluating a Stock’s Beta as an Investor
Investors can utilize beta in a number of ways:
- To help determine when a stock is outperforming expectations, given its risk
- To determine how the addition of a stock will affect the expected return of a portfolio
- To determine how the addition of a stock will affect the volatility of a portfolio
Beta is a number that is readily available through most stock information services. On the Seeking Alpha website, it appears on every stock page in the Risk section as shown below.
Advantages & Disadvantages of Measuring ‘Beta’
While beta can serve a number of purposes, it should be remembered that it is only a statistic derived from a specific prior period. Beta can be calculated for different periods, so two reported betas on the same security may not be the same.
Regardless, it's important to understand that beta is not a perfect predictor of future relative market volatility, and is effectively an approximation at best. A company's beta will move up and down over time.
Advantages
- Manage expectations: Beta represents a good indication of whether a particular stock will move more or less than the market as a percentage.
- Manage your portfolio volatility: Beta can help you manage the volatility of your overall portfolio and change it to accommodate changing market conditions.
- Simple: Beta is a relatively simple concept to understand and the number is readily available.
Disadvantages
- Beta is not constant: Betas will change as the nature of both the stock in question and the market as a whole evolve. The market’s makeup changes as stocks are added or subtracted from the index. Companies mature or change their businesses. The business and economic climate change. Beta, therefore, changes over time.
- Not reliable for very short-term projections: In addition, statistics become more accurate over longer periods of time. Therefore, using beta for short-term projections such as only a few days or weeks is particularly susceptible to error. A stock with a beta of >1.0 won't experience more volatility than the market each and every trading day.
Bottom Line
Beta can be helpful as a gauge of a stock’s volatility relative to the market or a particular portfolio and is a readily available measure. Like any statistic, though, it should be used as a guide and not as a precision predictor of future price action.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
