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When investing, be prepared for bumps along the way. The stock market moves up and down all the time, but the individual stocks that make up the market all move at different paces. Some may have higher highs and lower lows, and others may move in almost identical fashion to the market as a whole. Will a stock feel like a rollercoaster ride? Or will it feel more like you’re driving on the highway at the same pace as the car next to you?
Investors have developed a way to find this out: It’s called beta, and it can provide useful clues.
What is beta and how does it work?
Beta is a way of measuring the volatility of a stock compared to the volatility of the overall market. By definition, the market as a whole has a beta of 1, and everything else is defined relative to it:
- Shares with a value greater than 1 are more volatile than the market, meaning they typically rise more than the market rises and fall more than the market falls.
- Stocks with a beta of less than 1 have a smoother ride because their movements are more moderate than the market’s, but they will 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 in the opposite direction of the market. So when the market rises, these securities fall, and vice versa.
To calculate beta, investors divide the covariance of an individual stock (for example, Apple) with the overall market, often represented by the Standard & Poor’s 500 Index, by the variance of the market return compared to the average return. Covariance is a measure of how two securities move relative to each other.
Beta can help investors get a sense of the risk of a particular stock, and it’s a useful, if imperfect, way to do that.
Beta values can change over time because they are tied to market fluctuations. Investors use beta to tailor their portfolios to their risk tolerance levels, focusing on high-beta stocks for potentially higher returns with more risk, or low-beta stocks for added stability. However, it is essential to remember that while beta provides insight into expected price volatility, it does not predict the direction of price changes and should be evaluated in conjunction with other factors such as a stock’s fundamentals when making investment decisions.
Using beta to evaluate a stock’s risk
Beta allows a good comparison between an individual stock and a market-tracking index fund, but does not provide a complete picture of a stock’s risk. Instead, it looks at its level of volatility, and it is important to note that volatility can be good and bad. Investors don’t complain about upward price movements. The downward price movement will obviously keep people awake.
Compare the beta of different stocks the same way you would order food at a restaurant. If you’re a more risk-averse investor focused on earning income, you might shy away from high-beta stocks, just as someone with simpler tastes might prefer a simple dish with familiar ingredients and flavors. A more aggressive investor with a higher risk tolerance might be more inclined to chase high-beta stocks, the same way an adventurous eater seeks out new, spicy dishes with exotic ingredients he’s never tried before.
Beta is a data point that is available everywhere. You’ll come across this among other measures of a stock’s price when you do your research – which you should always do.
Pros and cons of using beta
Plus points
- History can hold important lessons: Beta uses a significant portion of the data. Beta typically reflects at least 36 months of measurements and gives you an idea of how the stock has performed relative to the market over the past three years.
- Numbers don’t lie: Instead of sifting through press releases about previous product launches or reading between the lines of what a company’s CEO might have said at last year’s investor day and how the stock reacted to these various news items, beta mathematically represents the price movements of the share. for you.
Cons
- You look in the rearview mirror: Beta is a backward-looking, unique measure that contains no other information. Of course it is good to think about what the past three years have looked like, but as an investor it is about what awaits you in the next three years. You want to think about business prospects and potential market disruptions on the horizon. Therefore, science is only part of your research.
- Numbers aren’t everything: Beta does not include qualitative factors that can play an important role in a company’s prospects. Has that renowned CEO stepped down in those three years? Now that the succession plan is in place, the future may look very different.
- The measurement does not work for young companies: Because there is a lot of hype surrounding IPOs, beta is a number that will never be part of the conversation. Because it is calculated based on historical price movements, you cannot effectively use beta to evaluate companies that have plans to go public, or to evaluate young companies that have recently listed on Wall Street.
In short
Beta helps investors understand a stock’s systematic risk and potential response to market changes. If the beta score is higher than 1, it implies a higher level of volatility, while a beta score lower than 1 indicates lower volatility. However, it is important to remember that beta is based on historical data and does not anticipate future price changes or a company’s core principles. So while beta can provide some insight into potential risks, it should be used as just one of many components in your investment decision-making process.
