Beta is a statistical measure of the volatility of a stock versus the overall market. It's generally used as both a measure of systematic risk and a performance measure. The market is described as having a beta of 1. The beta for a stock describes how much the stock’s price moves in relation to the market. If a stock has a beta above 1, it's more volatile than the overall market. As an example, if an asset has a beta of 1.3, it's theoretically 30% more volatile than the market. Stocks generally have a positive beta since they are correlated to the market.
If the beta is below 1, the stock either has lower volatility than the market or it's a volatile asset whose price movements are not highly correlated with the overall market. The price of Treasury bills (T-bills) has a beta lower than 1 because it doesn't move very much in relation to the overall market. Many consider stocks in the utility sector to have betas less than 1 since they're not very volatile. Gold, on the other hand, is quite volatile but has at times had a tendency to move inversely to the market. Lower beta stocks with less volatility do not carry as much risk, but generally provide less opportunity for a higher return.
The beta coefficient is calculated by dividing the covariance of the stock return versus the market return by the variance of the market. Beta is used in the calculation of the capital asset pricing model (CAPM). This model calculates the required return for an asset versus its risk. The required return is calculated by taking the risk-free rate plus the risk premium. The risk premium is found by taking the market return minus the risk-free rate and multiplying it by the beta.
The market against which to measure beta is often represented by a stock index. The most commonly used stock index is the S&P 500. The S&P 500 is used as the measure because of the high number of large-cap stocks included in the index, as well as the broad number of sectors included. The Dow Jones Industrial Average has also previously been the main measure of the market, but it has fallen out of favor since it only includes 30 companies and is very limited in its breadth.
Beta is an important concept for the analysis of hedge funds. It can show the relationship between a hedge fund’s returns and the market return. Beta can show how much risk the fund is taking in certain asset classes and can be used to measure against other benchmarks, such as fixed income or even hedge fund indexes. This measure can help investors determine how much capital to allocate to a hedge fund or whether they would be better off keeping their exposure in the equity market or even cash.