When you invest, be prepared to hit bumps along the way. The stock market moves up and down all the time, but the individual stocks that make up the market move at different rates. some may have higher highs and lower lows, and others may move almost identically to the market as a whole. Will an action feel like a roller coaster? Or will it feel more like you’re driving down a highway at the same pace as the car next to you?
investors have developed a way to find out: it’s called beta, and it can offer 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 general market. by definition, the market as a whole has a beta of 1, and everything else is defined relative 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 are softer as they move more moderately than the market, but will generally continue to rise when the market rises and down when the market goes down.
- Securities with a negative beta, which is unusual, will typically move inversely of the market. so when the market goes up, these values go down and vice versa.
To calculate beta, investors divide the covariance of an individual stock (for example, an apple) with the broader market, often represented by the standard & index of the poor 500, by the variance of the market’s returns compared to its average return. covariance is a measure of how two values move relative to each other.
beta can help give investors an idea of the risk in a given stock, and is a useful, if incomplete, way of doing it.
using beta to assess the risk of a stock
beta allows for a good comparison between an individual stock and a market-following index fund, but does not provide a complete picture of a stock’s risk. instead, it’s a look at your level of volatility, and it’s important to note that volatility can be both good and bad. investors do not complain about upward price movements. the downward price movement will, of course, keep people awake at night.
Think of comparing the beta of different stocks the same way you might order food at a restaurant. If you’re a more risk-averse investor focused on earning income, you might avoid high-beta stocks in the same way that someone with a simpler palate might prefer to order a simple dish with familiar ingredients and flavors. A more aggressive investor with a higher tolerance for risk might be more inclined to pursue high beta stocks in the same way that an adventurous eater will seek out new spicy dishes with exotic ingredients that he has never tried.
beta is a data point that is widely available. you’ll find this along with other stock price metrics when you do your research, which you should always do.
pros and cons of using beta
- the story may contain important lessons: the beta version uses a lot of data. Typically reflecting at least 36 months of measurements, beta gives you an idea of how the stock has moved against the market over the past three years.
- Numbers don’t lie: Instead of reviewing press releases about previous product launches or trying to read between the lines of what a company’s CEO might have said at investor day last year, and how stocks reacted to these various pieces of news, beta mathematically represents the stock moves for you.
- You’re looking in the rearview mirror: beta is a single retrospective measure that doesn’t incorporate any other information. Sure, it’s good to reflect on how the last three years went, but as an investor, what matters to you is what’s in store for the next three years. You want to think about the business outlook and potential market disruptions on the horizon. that’s why the beta is just one part of your research.
- Numbers aren’t everything: The beta doesn’t include qualitative factors that might play a role in a company’s perspective. Did that renowned CEO resign during those three years? now that the succession plan is in place, perhaps the future looks a bit different.
- The measure does not work with young companies: as there is a lot of hype around to IPOs, beta is a number that will never be part of the conversation. Because it’s calculated on historical price movements, you can’t use the beta effectively to evaluate companies that have plans to go public or young companies that recently went public.