What is Beta

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark. 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 reflects the tendency of a security's returns to respond to swings in the market. A security's beta is calculated by dividing the product of the covariance of the security's returns and the benchmark's returns by the product of the variance of the benchmark's returns over a specified period. The most common formula for beta is as follows:

Cov(RaRb): Covariance of asset and market

Va(Ra): Variance of market

The above calculation is designed to (a) help investors understand whether a stock moves in the same direction as the rest of the market and (b) how volatile it is compared to the market. For beta to provide any insight, the “market” is used as a benchmark and should be related to the stock. For example, calculating a bond ETF’s beta by using the S&P 500 as the benchmark isn’t helpful because bonds and stocks are too dissimilar.

The benchmark used in the calculation should be related to the stock because an investor is trying to gauge how much risk a stock is adding to a portfolio. A stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, but it also doesn’t increase the theoretical potential for greater returns.

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Understanding Beta

Using R-Squared to Validate Beta

In order to make sure a stock is being compared to the right benchmark it should have 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 (GLD), is tied to the performance of gold bullion. Consequently, a gold ETF would have a low beta and R-squared in relation to the S&P 500, for example. 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

One way for a stock investor to think about risk is to split it into two categories. The first category is called “systemic risk” which is the risk of the entire market declining. The financial crisis in 2008 is an example of a systemic risk event when no amount of diversification could prevent investors from losing value in their stock portfolios. Systemic risk is also known as “undiversifiable risk”. Unsystemic risk or idiosyncratic risks are associated with an individual stock. The surprise announcement that Lumber Liquidators (LL) had been selling hardwood flooring with dangerous levels of formaldehyde in 2015 is an example of unsystemic risk. Unsystemic risk can be partially mitigated through diversification.

If a stock has a beta of 1.00, it indicates that its price is correlated with the market. A stock like that has systemic risk, but the beta calculation can’t detect any unsystemic risk. Adding a stock to a portfolio with a beta of 1.00 doesn’t add any risk to the portfolio, but it also doesn’t increase the likelihood that the portfolio will provide excess return.

A beta of less than 1.00 means that the security is theoretically less volatile than the market which means the portfolio is less risky with the stock included than without it. For example, utility stocks often have low betas because they tend to move more slowly than market averages.

A beta that is greater than 1.00 indicates that the security's price is theoretically more volatile than the market. For example, if a stock's beta is 1.20, it is assumed to be 20% more volatile than the market. Technology stocks and small caps tend to have higher betas than the market benchmark. This indicates that adding the stock to a portfolio will increase the portfolio’s risk, but also increase its expected return.

Some stocks even have negative betas. A beta of -1.00 means that the stock is inversely correlated to the market benchmark as if it were a mirror image of the benchmark’s trends. Put options or inverse ETFs are designed to have negative betas but there are a few industry groups – like gold miners – where a negative beta is also common.

Beta in Theory vs. Beta in Practice

The beta coefficient assumes that stock returns are normally distributed from a statistical perspective. However, financial markets are prone to large surprises, so we know that returns aren’t normally distributed. Therefore, what beta might predict about a stock’s movement isn’t always true.

A stock with a very low beta could have smaller price swings and yet still be in a long-term downtrend. In this case adding a down trending stock with a low beta only decreases risk in a portfolio if we define risk as a function of volatility rather than the potential for losses. From a practical perspective, a low beta stock in a downtrend isn’t likely to improve a portfolio’s performance.

Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio but add gains as well. Investors using beta to evaluate a stock will need to evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio.

Summary of Beta

A stock’s beta or beta coefficient is a measure of the stock’s level of systemic and unsystemic risk based on in its prior performance. The beta of an individual stock only tells an investor theoretically how much risk the stock will add (or potentially subtract) from a diversified portfolio. For beta to be meaningful, the stock and the benchmark used in the calculation should be related.

Using beta to choose stocks is certainly a way to avoid volatility and a way to create a diversified portfolio. A brokerage account would be needed to put your findings into practice. If you do not yet have a brokerage account, you can read Investopedia's list of the best online stock brokers. That list may be able to help you choose a broker so you can start building your portfolio.

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