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In investing, beta does not refer to fraternities, product testing or VHS' old competition - in investing, beta is a measurement of market risk, or volatility. It is because of this risk that some people don't want to invest in stocks. These risk-averse investors can't stomach stocks' greater tendency to fluctuate in price. Sure, there is always the possibility that a stock will lose some or all of its value, but volatility also makes it possible for investors to make a great deal of money - if they make the right choices.
What Is the Beta?
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall market. In other words, it gives a sense of the stock's market risk compared to the greater market. Beta is used also to compare a stock's market risk to that of other stocks. Investment analysts use the Greek letter 'ß' to represent beta.
This measure is calculated using regression analysis. A beta of 1 indicates that the security's price tends to move with the market. A beta greater than 1 indicates that the security's price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utility stocks have a beta of less than 1, and, conversely, many high-tech Nasdaq-listed stocks have a beta greater than 1.
Essentially, beta expresses the fundamental tradeoff between minimizing risk and maximizing return. Let's give an illustration. Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company. (For further reading, see Beta: Know The Risk.)
Here is a basic guide to various betas:
- Negative beta - A beta less than 0 - which would indicate an inverse relation to the market - is possible but highly unlikely. Some investors used to believe that gold and gold stocks should have negative betas because they tended to do better when the stock market declined, but this hasn't proved to be true over the long term.
- Beta of 0 - Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
- Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.
- Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market, against which other stocks and their betas are measured. The S&P 500 is such an index. If a stock has a beta of one, it will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.
- Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Again, as we mentioned above, many technology companies on the Nasdaq have a beta higher than 1.
- Beta greater than 100 - This is impossible as it essentially denotes a volatility that is 100 times greater than the market. If a stock had a beta of 100, it would be expected to go to 0 on any decline in the stock market. If you ever see a beta of over 100 on a research site it is usually the result of a statistical error, or the given stock has experienced large swings due to low liquidity, such as an
over-the-counter stock. For the most part, stocks of well-known companies rarely ever have a beta higher than 4.
Why You Should Know What Beta Is
Are you prepared to take a loss on your investments? Many people are not and therefore opt for investments with low volatility. Other people are willing to take on additional risk because with it they receive the possibility of increased reward. It is very important that investors not only have a good understanding of their risk tolerance, but also know which investments match their risk preferences.
And, by using beta to measure volatility, you can better choose those securities that meet your criteria for risk. Investors who are very risk averse should put their money into investments with low betas such as utility stocks and Treasury bills. Those investors who are willing to take on more risk may want to invest in stocks with higher betas.
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