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What is '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. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.

Calculating 'Beta'

Beta is calculated using regression analysis. Beta represents the tendency of a security's returns to respond to swings in the market. A security's beta is calculated by dividing the covariance the security's returns and the benchmark's returns by the variance of the benchmark's returns over a specified period.

Using Beta

A security's beta should only be used when a security has a high R-squared value in relation to the benchmark. The R-squared measures the percentage of a security's historical price movements that could be explained by movements in a benchmark index. For example, a gold exchange-traded fund (ETF), such as the SPDR Gold Shares, is tied to the performance of gold bullion. Consequently, a gold ETF would have a low beta and R-squared in relation to a benchmark equity index, such as the Standard & Poor's (S&P) 500 Index. When using beta to determine the degree of systematic risk, a security with a high R-squared value, in relation to its benchmark, would increase the accuracy of the beta measurement.

Interpreting Beta

A beta of 1 indicates that the security's price moves with the market. A beta of less than 1 means that the security is theoretically less volatile than the market. A beta of greater than 1 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Conversely, if an ETF's beta is 0.65, it is theoretically 35% less volatile than the market. Therefore, the fund's excess return is expected to underperform the benchmark by 35% in up markets and outperform by 35% during down markets.

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. For example, as of May 31, 2016, the PowerShares QQQ, an ETF tracking the Nasdaq-100 Index, has a trailing 15-year beta of 1.27 when measured against the S&P 500 Index, which is a commonly used equity market benchmark.

Test your beta knowledge and read more here: Beta: Know the Risk and Calculating Beta: Portfolio Math for the Average Investor.

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