When you invest, be prepared to encounter bumps along the way. The stock market moves up and down all the time, but the individual stocks that comprise the market all move at different paces. Some might have higher highs and lower lows, and others might move in nearly identical fashion to the market as a whole. Will a stock feel like a roller-coaster ride? Or will it feel more like you’re driving on a highway at the same pace as the car next to you?
Investors have developed a way to tell: It’s called beta, and it can offer helpful clues.
What is beta, and how does it work?
Beta is a way of measuring a stock’s volatility compared with the overall market’s volatility. By definition, the market as a whole has a beta of 1, and everything else is defined in relation to that:
- Stocks with a value greater than 1 are more volatile than the market, meaning they will generally go up more than the market goes up, and go down more than the market goes down.
- Stocks with a beta of less than 1 have a smoother ride as their moves are more muted than the market’s, but they’ll usually still go up when the market goes up and down when the market goes down.
- Securities with a negative beta, which is unusual, will typically move inversely to the market. So when the market goes up, these securities fall, and vice versa.
To calculate beta, investors divide the covariance of an individual stock (say, Apple) with the overall market, often represented by the Standard & Poor’s 500 Index, by the variance of the market’s returns compared to its average return. Covariance is a measure of how two securities move in relation to one another.
Beta can help give investors an idea of the risk in a given stock, and it’s a useful, if incomplete, way of doing so.
Using beta to evaluate a stock’s risk
Beta allows for a good comparison between an individual stock and a market-tracking index fund, but it doesn’t offer a complete portrait of a stock’s risk. Instead, it’s a look at its level of volatility, and it’s important to note that volatility can be good and bad. Investors aren’t complaining about upward price movements. The downward price movement, of course, will keep people up at night.
Think of comparing the beta of different stocks in the same way you might order food at a restaurant. If you are a more risk-averse investor who is focused on earning income, you might shy away from high-beta stocks the same way that someone with a simpler palate might prefer to order a plain dish with familiar ingredients and flavors. A more aggressive investor with a higher risk tolerance might be more inclined to chase the high-beta stocks the same way an adventurous eater will look for new, spicy dishes with exotic ingredients they have never tried.
Beta is a data point that is widely available. You’ll find this alongside other metrics of a stock’s price when doing your research — which you should always do.
Pros and cons of using beta
Pros
- History can hold important lessons: Beta uses a sizable chunk of data. Typically reflecting at least 36 months of measurements, beta gives you an idea of how the stock has moved vs. the market over the last three years.
- Numbers don’t lie: Rather than combing through press releases about past product launches or trying to read between the lines of what a company’s CEO might have said at the investor day last year, and how the stock reacted to these various pieces of news, beta mathematically represents the stock’s moves for you.
Cons
- You’re looking in the rearview mirror: Beta is a backward-looking, singular measure that doesn’t incorporate any other information. Sure, it’s good to reflect on what the past three years looked like, but as an investor, what you care about is what’s in store for the next three years. You want to think about business prospects and potential market disruptions on the horizon. That’s why beta is only one part of your research.
- Numbers aren’t everything: Beta doesn’t include qualitative factors that can play a significant role in a company’s outlook. Did that renowned CEO step down during those three years? Now that the succession plan is in place, perhaps the future will look quite a bit different.
- The measurement doesn’t work with young companies: As plenty of hype swirls around IPOs, beta is one number that will never be part of the conversation. Because it’s calculated on historical price movements, you can’t effectively use beta to evaluate companies that have plans to go public or young companies that have recently been listed on Wall Street.
FAQs
Beta helps investors understand the systematic risk of a stock and its potential reaction to market changes. If the beta score exceeds 1, it implies a higher level of volatility, whereas a beta score below 1 indicates lower volatility.
What beta means when considering a stock's risk? ›
Key Takeaways. Beta is a concept that measures the expected move in a stock relative to movements in the overall market. A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
How is beta used to measure risk? ›
The beta for a stock describes how much the stock's price moves compared to the market. If a stock has a beta above 1, it's more volatile than the overall market. For example, if an asset has a beta of 1.3, it's theoretically 30% more volatile than the market.
What is the beta in terms of risk? ›
The beta (β) of an investment security (i.e., a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.
How do you evaluate the beta of a stock? ›
The first is to use the formula for beta, which is calculated as the covariance between the return (ra) of the stock and the return (rb) of the index divided by the variance of the index over three years.
Does high beta mean high risk? ›
Volatility is usually an indicator of risk, and higher betas mean higher risk, while lower betas mean lower risk. Stocks with higher betas may gain more in upward markets but lose more in downward markets. Covariance is the measure of a stock's return relative to that of the market.
What does a beta of 0.8 mean? ›
For example, a stock with a beta value of 0.8 means that stock is only 80% as volatile with its price swings compared with the overall market index. Another way to look at this is that the stock is 20% less volatile than the overall stock market.
What does a beta of 1.6 mean? ›
A negative beta means that an investment moves in the opposite direction as the overall stock market. For example, Johnson & Johnson has a beta of 0.7, meaning that it is less volatile than the overall market, while Amazon.com has a beta of 1.6, indicating that investors should expect higher volatility.
What does a beta of 0 mean? ›
A zero-beta portfolio would have the same expected return as the risk-free rate. Such a portfolio would have zero correlation with market movements, given that its expected return equals the risk-free rate or a relatively low rate of return compared to higher-beta portfolios.
Why is beta a better measure of risk than standard deviation? ›
While standard deviation determines the volatility of a fund according to the disparity of its returns over a period of time, beta, another useful statistical measure, compares the volatility (or risk) of a fund to its index or benchmark.
However, it's important to remember that beta is based on historical data and doesn't anticipate future price changes or the core principles of a company. So, while beta can provide some insight into potential risk, it should be used as just one component among many in your investment decision-making process.
What are the three types of risk and beta? ›
Systematic Risk – The overall impact of the market. Unsystematic Risk – Asset-specific or company-specific uncertainty. Political/Regulatory Risk – The impact of political decisions and changes in regulation.
Does lower beta mean less risk? ›
A higher beta indicates a stock is more volatile than the market and carries more risk—but generally has the potential for higher returns. On the other hand, low-beta stocks typically pose less risk but yield lower returns.
What does beta tell you about a stock? ›
Beta indicates how volatile a stock's price is in comparison to the overall stock market. A beta greater than 1 indicates a stock's price swings more wildly (i.e., more volatile) than the overall market. A beta of less than 1 indicates that a stock's price is less volatile than the overall market.
What is a good beta? ›
A beta of 1 indicates that a stock's volatility is in line with the overall market. This can be seen as a neutral or average level of risk. Stocks with betas less than 1 are generally considered less risky than the market, while stocks with betas greater than 1 are generally considered more risky.
How do you calculate beta problems? ›
The formula for the beta of an individual stock within a portfolio takes the covariance divided by the variance. Investors can also find the correlation between the market index standard, multiply it by the stock's standard deviation and divide it by the market index's standard deviation.
Is higher or lower beta more risky? ›
A higher beta indicates a stock is more volatile than the market and carries more risk—but generally has the potential for higher returns. On the other hand, low-beta stocks typically pose less risk but yield lower returns.
What does beta 5Y monthly mean? ›
Beta (5Y Monthly): This value represents the relative volatility of the stock as compared to the market moves. A higher beta may indicate a higher risk with possibly higher returns.
What does high beta mean in investing? ›
A high beta index refers to a market index that is made up of stocks with higher-than-average volatility as compared to the overall stock market. Some investors aim to maximize returns on investment by investing in high beta stocks, especially during periods when the overall stock market is extremely bullish.
