Every investor strives to balance two conflicting goals: Maximizing their investment returns and minimizing their risk. Beta offers a way to measure the amount of risk you’re taking on for a given investment return.
Beta, often represented by the Greek letter β, is a way of measuring the volatility of the returns you get from an investment. Volatility is a measure of how much and how quickly the value of an asset rises and falls. In financial markets, risk and volatility are closely related concepts.
Investors use beta to see whether the price of a security is moving in the same direction as the rest of the market. It also provides insights about how volatile—or how risky—a stock is relative to the rest of the market.
Beta as a Measure of Risk
Risk is an unavoidable part of investing, but it’s also the driver of your returns. Investors look for ways to understand risk, mitigate it and measure it.
Risk comes in two varieties, unsystemic and systemic. Unsystemic risk is unique to each security and can be diversified away in an investment portfolio. Systemic risk is the overall market risk and cannot be fixed with diversification.
Beta allows investors to understand the systemic market risk of an individual security. Therefore it plays a pivotal role in portfolio construction.
For beta to provide any useful insight, the market used as a benchmark should be related to the investment asset in question. For example, calculating a bond ETF’s beta using the S&P 500 as the benchmark would not provide much insight because bonds and stocks are too dissimilar.
How to Calculate Beta
Beta is often calculated using something called regression analysis plotting, which compares a stock’s returns against those of the overall market.
You can calculate beta in an excel spreadsheet. You’ll need the stock’s daily closing price each day during the timeframe you specify, and the benchmark’s closing price for the same period.
Open your spreadsheet and enter the date of each day in your specified timeframe. Stock prices go in the second column and benchmark prices in the third. Next, calculate the daily price changes for each (subtract current day price from previous day price, divide by the previous day price and multiply by 100).
Next, calculate the covariance for stock and index prices. Covariance is how you measure a changing relationship between two entities. In this case, covariance will show you how changes in stock returns relate to changes in market returns.
Finally, calculate the variance of the index (derived from the index daily price changes to show how they are distributed around the average), and divide the covariance by the variance. This will give you that particular stock’s beta.
Obviously, this can be a great deal of effort. If you prefer, there are online beta calculators that can make the process easier.
What Does Beta Tell You About a Stock?
Beta is expressed as a number that shows the stock’s volatility around the index. A beta of one suggests that the stock moves in sync with the market.
A beta higher than one shows that a stock’s price is more volatile than the market. For example, a beta of 1.3 suggests that the stock is 30% more volatile than the market.
Some types of stocks, like those in cyclical industries, have higher betas. One such sector is consumer retail, which is dependent on frequently shifting consumer sentiment.
High beta stocks make portfolios riskier but increase the chance of higher returns.
A beta lower than one suggests that a stock is less risky than the market. A beta of .5 suggests that the stock is 50% less volatile than the market. Adding this type of stock to a portfolio lowers the overall risk but has a similar effect on potential return. Stocks in sectors like utilities, consumer staples and healthcare have low betas because these businesses provide things that people can’t do without.
Stocks with negative betas move in the opposite direction of the market.
Gold and gold stocks are likely to have negative betas since these are assets that appreciate when the market declines.
Beta and the Capital Asset Pricing Model
Beta plays a significant role in the capital asset pricing model (CAPM), which describes the relationship between market, or systemic risk, and expected return. It gives investors a way to relate expected return to the level of risk they assume.
Investment professionals use this expected return, in conjunction with other valuation methods, as a basis for investment decisions.
Disadvantages of Beta
Beta can be a useful tool in analyzing a stock, but it has its limitations. First, beta is calculated using historical market data so it’s less useful for investors who want to predict future movements in prices.
Moreover, a stock’s level of volatility may change over time as its circumstances change. This makes beta less practical when looking at long-term investments.
Beta also ignores company fundamentals. Risk levels can change dramatically depending on business strategies.
For example, a formerly low beta company can overextend itself by borrowing heavily to fund expansion, or it might acquire a firm in a new sector to gain a foothold.
How to Use Beta for Investing
The most rudimentary way to use beta is to realize that high beta stocks could increase your portfolio risk while low beta stocks could reduce it. Expected returns should rise or fall inversely.
Taking a more sophisticated approach and using the CAPM, you can understand how the level of systemic risk impacts the expected return. In the short-term, beta can give frequent traders an indication of risk.
However, don’t rely solely on beta as your measure of risk. It’s not a forward-looking metric, so take the time for fundamental research to augment your analysis.
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Article initially appeared on nasdaq.com
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