What is beta?
Beta is a number that helps rate how dramatically a stock is expected to move compared to the broader market.
🤔 Understanding beta
There’s no way to perfectly predict the fate of a stock, but there are some metrics that can help us figure out how risky a particular investment might be. Beta is one of those figures. Beta is a single figure that indicates how volatile a stock or other traded investment is compared to the stock market as a whole. While the market benchmark is assigned a beta of 1, a lower beta (< 1) suggests that the stock will move less dramatically than the stock market, at least in the short term. Similarly, a beta greater than 1 means that the stock is expected to fluctuate more than the stock market. While investments with lower betas are generally considered to be less risky, lower betas can also signal less opportunity for reward.
Tech stocks and small cap stocks (companies that are valued between $300M and $2B) tend to have higher betas than the overall market, which has a beta of 1. Teva Pharmaceutical Industry’s 2.49 beta, for example, indicates that the stock is expected to be more than twice as volatile than the market, while Intel’s beta of 0.6 means the stock will typically move at a rate that’s only about half that the broader market (data from Yahoo Finance, June 13, 2019).
Beta's a tool to measure a stock's volatility...
Beta compares the movement of a stock to the broader moves of the market, warning you how sensitive that stock is to market movements. The more volatile a stock or other traded investment is, the higher its beta tends to be, and the less volatile, the lower the beta.
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How is beta calculated?
Beta is calculated by comparing the rate at which a stock or security moves on the market with how the market swings more broadly.
In math speak, the official equation is: beta = the covariance (how changes in a stock’s performance relate to changes in the market’s returns) divided by the variance (how far the market’s data points differ from their average value over a specific period of time).
It’s basically an exercise in calculus that compares the steepness or slope of a stock’s path to the slope of the market over a set amount of time. The steeper the stock or security’s slope, the higher the beta.
Why beta matters
The future of stocks and other securities can be pretty tough to predict. So, investors look to beta as a tool for getting a little more insight into how much a security might move in the near term. Knowing that a stock has a really high beta, for example, can signal to an investor that it could have a high probability of being more volatile than the stock market, and to what degree. It’s ultimately based on the historical movements of a particular security, and the broader market.
Like checking a tide forecast before getting in the ocean, beta helps people know what level of risk or movement they could be getting into with a particular stock. With a beta of 1.52, for example, Shopify is expected to be more volatile than the overall market, while at 1.03, Apple’s beta indicates its share fluctuations are expected to align closely with the stock market. Meanwhile, Fitbit, with a beta of 0.77, is likely to move less dramatically than the stock market, which suggests it's on the less risky side of potential stock investments (Source: Yahoo Finance, June 13, 2019).
Investors like to keep tabs on the overall risk of their portfolio to make sure that they keep their overall risk within their comfort zone. Reviewing the betas of the stocks and securities in a broader portfolio can help an investor get a better feel for how risky or cautious their overall investment portfolio might be. If a portfolio is more risky than the owner would like, he or she can diversify the portfolio by distributing his investments across a larger number of investments with different risk levels.
The riskiness of a security comes with its pros and cons. Stocks with lower betas are less volatile, but theoretically have less potential to generate returns than stocks that have higher betas. Meanwhile, stocks with high betas are expected to have the ability to generate higher returns, but there’s more risk - higher returns aren’t guaranteed and there’s a greater risk of losing money on the investment.
Another handy use for beta: analysts can use it in different investing equations (for example, the capital asset pricing model) to help calculate the expected return of a security given its risk.
What are the limitations of beta?
While beta can be a helpful way of rating a security’s risk, it’s not a silver bullet:
- Short-term insight: Beta is usually helpful only for anticipating the short-term volatility of a stock or security, not the long-term performance of a stock.
- Nothing’s guaranteed: Sometimes a company’s stock moves in a way that goes against what its beta predicted. For example, a stock with a beta less than 1 that’s expected to swing more midly than the market, could end up being very volatile. Beta is a signal, not a fool-proof prediction.
Can beta be negative?
Although the bulk of companies have betas that are positive, it is possible in rare cases that beta can be negative. Gold and mining companies, for example, sometimes have negative betas. A few examples: Gold mining companies Agnico Eagle Mining has a beta of -0.56, while Newmont Gold has a beta of -0.34 (Source: Yahoo Finance, June 13, 2019).
A negative beta means the stock or security is expected to swing opposite of the overall market. If the market surges, a security with a negative beta is expected to decline. Likewise, if the market plummets, a stock with a negative beta is expected to rise.
Disclosure: Diversification does not ensure a profit or protect against a loss. 20190617-875554-2639820
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