What Is a Stock’s Beta?
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Beta is a measure of a stock’s historical volatility in comparison with that of a market index such as the S&P 500.
Stocks with a beta above 1 tend to be more volatile than their index, while stocks with lower betas tend to be less volatile.
High-beta stocks tend to increase a portfolio’s overall volatility and low-beta stocks tend to decrease it.
However, beta is a backward-looking metric which only measures one kind of risk.
You can make almost anything sound smarter by adding Greek letters to it — and investing is no exception.
When you strip away the fancy terminology, a stock’s beta (β) is simply a measure of how risky that stock is. Beta analysis can be a useful tool for building a balanced portfolio, although it has limitations.
What does beta mean in stocks?
Beta is a way of measuring how volatile an investment is, compared with a market index such as the S&P 500. It’s used to evaluate the expected risks and returns of a portfolio, or to see whether a specific investment would be a good fit for a portfolio in terms of expected risks and returns.
A stock with a beta of 1 would be expected to move exactly in sync with its index. If the S&P 500 rose by 1% in a day, then that stock would also rise by 1%. If it fell by 1%, that stock would also fall by 1%.
If its beta were greater than 1, it would be expected to be more volatile than the index — in other words, bigger increases and decreases. If the S&P 500 rose by 1% in a day, then a stock with a beta of 1.5 would rise by 1.5%. If the index fell by 1%, that stock would fall by 1.5%.
If its beta were less than 1, it would be expected to be less volatile than the index — smaller increases and decreases. So a stock with a beta of 0.7 would rise by 0.7% on a day that the S&P 500 rose 1%, and would fall by 0.7% on a day that the S&P 500 fell 1%.
Cash effectively has a beta of zero, because its value has no correlation with any stock market index. Cash doesn’t increase or decrease in value along with the S&P 500.
Some investments — such as put options — have negative betas, meaning that they would be expected to move in the opposite direction of the index. If a put option had a beta of -1.5, it would fall by 1.5% on a day that the S&P 500 rose by 1%, and would rise by 1.5% on a day that the S&P 500 fell by 1%.
How to calculate a stock’s beta
A stock’s beta is equal to the covariance of the stock’s returns and its benchmark index’s returns over a particular time period, divided by the variance of the index’s returns over that period.
As a formula, β = covariance(stock returns, index returns) / variance(index returns).
If this sounds confusing, don’t worry. You don’t need to do college-level statistical calculations by hand to find a stock’s beta (unless you want to, for some reason).
For the rest of us, it’s much easier to calculate beta in spreadsheet programs such as Microsoft Excel or Google Sheets, which have built-in variance and covariance formulas.
Or, even easier, you could just look up a stock’s beta online.
Many financial data websites, such as Yahoo Finance and FinViz, will display a stock’s beta along with other metrics, including PE ratio and year-to-date performance if you search the stock’s ticker symbol.
Yahoo Finance’s beta calculations are based on monthly returns over the last five years, while FinViz doesn’t specify the data it uses to calculate beta.
What is a good beta for a stock?
There is no single answer to the question, “what is a good beta?” It depends on what you’re trying to do to your portfolio and how an investment with a high or low beta will affect it.
If you feel that your portfolio is too conservative or stagnant — that you’re missing out on gains because your investments don’t move very much — then it’s likely that your portfolio as a whole has a beta of less than 1. Adding stocks with a beta greater than 1 would add more volatility relative to the market (and the potential for higher returns).
Conversely, if you feel that your portfolio is too risky — that you can’t stomach its big upward and downward swings — then there’s a good chance that your portfolio has a beta greater than 1. Adding stocks with betas of less than 1 would help decrease volatility relative to the market.
Limitations of beta analysis
Beta analysis can be a useful way to manage the level of risk in your portfolio, but like any financial technique, it’s not perfect.
One major drawback of beta is that it’s a backward-looking metric. It’s calculated based on past returns, which may not be consistent with future returns.
For example, if a company with a previously low beta suddenly starts making riskier business decisions and experiencing more dramatic stock price swings, its five-year monthly beta may not increase for several months or even years.
Beta’s backward-facing nature also means it’s not very useful for evaluating younger publicly traded companies without long-term track records.
It’s also worth noting that beta only measures one kind of risk: systematic risk, or how a stock will respond to upturns or downturns in the overall market. It doesn’t include any information on how a company is actually run. Earnings, cash flow, debt and dividends are all important fundamental measures of a company, but none directly affects a stock’s beta.
The bottom line on beta
Looking at the beta of a portfolio — and the betas of stocks you’re considering adding to that portfolio — can be a useful tool for managing risk, as high-beta stocks tend to increase a portfolio’s overall volatility and low-beta stocks tend to decrease it.
But remember that beta is a backward-looking measure of one specific type of risk. Consider looking at a stock’s fundamentals along with its beta when deciding whether to add it to your portfolio.