Introduction - Beta
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio, in comparison to the market as a whole. Think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
Many utilities stocks have a beta of less than 1. Conversely, most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
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. If we expect the market to provide a return of 10% on an investment, then 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.
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.
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.
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.
Many brokerage firms calculate the betas of securities they trade and then publish their calculations in a beta book. These books offer estimates of the beta for almost any publicly-traded company. The problem is that most of us don't have access to these brokerage books and the calculation for beta can often be confusing, even for experienced investors.
However, there are other resources. One of the better websites that publishes beta is Yahoo! Finance (enter your company name, then click on "Key Statistics" and look under "Stock Price History"). The beta that is calculated on Yahoo! compares the activity of the stock over the last five years with the S&P 500. A beta of "0.00" simply means that the stock either is a new issue or doesn't yet have a beta calculated for it.
The most important caveat for using beta to make investment decisions is that beta is a historical measure of a stock's volatility. Past beta figures, or historical volatility, do not necessarily predict future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee that in a year the beta will be the same. One study by Gene Fama and Ken French called "The Cross-Section of Expected Stock Returns" (published in 1992 in the Journal of Finance) on the reliability of past beta concluded that for individual stocks, past beta is not a good predictor of future beta. An interesting finding in this study is that betas seem to revert back to the mean. This means that higher betas tend to fall back toward 1 and lower betas tend to rise toward 1.
The second caveat for using beta is that it is a measure of systematic risk, which is the risk that the market as a whole faces. The market index to which a stock is being compared is affected by market-wide risks. So, as beta is found by comparing the volatility of a stock to the index, beta only takes into account the effects of market-wide risks on the stock. The other risks the company faces are firm-specific risks that are not grasped fully in the beta measure. So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks the company, alone, faces.
It is also important for investors to make the distinction between short-term risk - where beta and price volatility are useful - and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities.