We often hear the word beta in the context of “beta test”. It’s a way of testing something (e.g. a software program) in a real-world situation to iron out any glitches before rolling it out to the public.
The word beta in the context of investing means something different, or does it? Understanding beta can help investors understand why a company may be performing or underperforming. In this way, beta can help investors predict how a stock is likely to perform before they buy the stock.
This article will define what beta is, key terms to help investors understand beta, the difference between provided beta and personally calculated beta, what beta indicates, how beta can be used for diversifying a portfolio, and finally a couple of limitations to beta.
What is beta?
Beta is the result of a calculation that measures the relative volatility of a stock in correlation to a particular standard. For U.S. stocks that standard is usually, but not always, the S&P 500. Beta can also be used by investors to evaluate a particular stock’s expected rate of return, particularly when using the Capital Asset Pricing Model (CAMP).
Beta is a form of regression analysis and it can be useful for investors regardless of their risk tolerance. Beta is considered one of the few data points that can be beneficial for practitioners of fundamental analysis and technical analysis. Investors who tend to analyze stocks using fundamental analysis will use beta along with the price-to-earnings ratio, shareholders equity, debt-to-equity ratio, and other factors. Technical analysts will use beta as an indicator of stocks that offer the price movement they are seeking. They will use beta along with other indicators such as average daily trading volume (ADTV) and a stock’s moving average.
What are the key terms related to beta?
Although investors will typically not have to calculate beta for themselves, it’s helpful to understand the meaning of two variables that are used in the formula for beta. These variables are covariance and variance.
- Covariance is a measurement of how two stocks move together. If the number is positive it means the price movement is generally correlated (i.e. when one stock goes up, so does the other and vice versa). If the number is negative, it means the price movement is generally not correlated (i.e. when one stock goes up, the other goes down and vice versa).
- Variance measures how far a stock moves in relation to its mean. In the case of beta, the mean is whatever benchmark is being used.
Should you calculate your own beta?
The simple answer is yes, but the calculation for the beta can be a little complex. In many cases, a financial website will give you what’s known as the “provided beta” for a particular stock. For active traders, financial software programs will also provide the beta value. When using a provided beta, investors should pay attention to two variables.
First, it’s important to understand what benchmark is being used to determine beta. Since the beta shows a correlation between a particular security and something, an investor needs to know what that something is. As pointed out above, for U.S. stocks it is common for beta to be expressed as a correlation to a stock index, usually the S&P 500, but not always. In some cases, the Dow Jones Industrial Average (DJIA) may be used, or even the NASDAQ.
The second thing an investor will need to know about a stock’s beta is the time frame that is being measured. If you’re a long-term investor, you may want to know the beta over several years. If you’re an active trader, you’ll probably be more interested in the beta over a much more recent timeframe.
A personally calculated beta, on the other hand, is one that investors will calculate for themselves. To calculate beta, investors will have to know the covariance between the return of the stock being analyzed and the return of the benchmark for that stock as well as the variance of the market returns.
As we mentioned above, many financial software programs will do the calculation for you. It is also possible to use an Excel spreadsheet to calculate beta. For many investors, particularly those who are engaging in day trading, a personally calculated beta may be more accurate for their needs.
How to interpret a stock’s beta number
Beta can get confusing if an investor gets hung up on positive and negative. When an investor sees a negative number, they instinctively think a stock is falling (i.e. generating a negative return). That is not necessarily the case with a negative beta. Here’s why:
As we defined it above, beta is a correlation between the price movement of a security and a benchmark related to that security. For these examples, let’s assume an investor is buying a U.S. stock that is being benchmarked to the S&P 500.
The beta of the S&P 500 is 1. The simplest explanation for this is that in establishing a benchmark, you’re dividing one thing by itself and that will always equal 1. Don’t confuse yourself anymore.
So knowing the beta of the S&P 500 is 1, here’s how investors can interpret the beta of a particular stock:
Beta of 1– this means a stock is highly correlated to the S&P 500. This means that if the S&P 500 index is up for the day, the stock is more than likely going to be up for the day and vice versa. A beta of 1 also means that price movement will probably be very similar. In other words, if you were to overlay the stock’s price movement over the S&P 500, the two lines would look very similar.
Beta of less than 1– this means a stock is not very correlated with the market. Sometimes it will follow the trend in the market, but sometimes it won’t. In terms of price movement, a beta of less than 1 is indicating that the stock is less volatile (i.e. less reactive to price movements in the broader market).
Beta of more than 1 – this also means a stock is not very correlated to the market. However, unlike a beta of less than 1, this means a stock is more volatile (i.e. more reactive to price movements in the broader market).
Beta of less than 0 (i.e. a negative beta)– this means a stock is inversely correlated to the market. The tendency of the stock is to move in the opposite direction as the market. The higher the negative number, the more volatile the stock.
As you can see, with beta one key thing to know is its relationship to the number 1. The closer the number is to 1, the more it is correlated to the market, the further it is from 1, the less it is correlated. Another key to understanding beta is that it’s a multiplicative factor. So a beta of 1.3 would mean that a stock is 30% more volatile than the market. First and foremost, beta is about projecting risk, not return.
Let’s go through some examples.
- Microsoft has a beta of around 1.25. This means an investor can reasonably expect that this stock is 25% more volatile than the market. This would be somewhat expected of a stock like Microsoft that is in the technology sector.
- Walt Disney Company has a beta right around 1.03. This puts its volatility right in line with the broader market. This is what you might expect from a blue-chip stock.
- In contrast, Duke Energy has a beta of around 0.27. This means it is not a very volatile stock, which is what investors would expect from a utility stock. This doesn’t mean that the stock is underperforming.
A beta can also be much higher than 1. There are some stocks that can have a beta of 2 or more.
This brings to mind a third, and perhaps the most important thing to know about beta. Beta is not an indication of price performance, but rather of potential volatility. A positive beta does not mean that a stock is going up in price. In fact, a stock that has a positive beta while the market is falling is more than likely falling at a higher percentage rate than the market. Likewise, a negative beta does not mean that a stock is going down in price. When the market is trending lower, these stocks will tend to be rising. A negative beta also does not mean that a company is underperforming. It just may be in a sector that will naturally work in opposition to the broader market. Stocks of gold mining companies and gold ETFs are a good example of this. You would expect these stocks to have a negative beta compared to the market because gold (and many other precious metals) tend to rise when the market falls and vice versa.
How to use beta for diversification
Now that you understand how to interpret beta, let’s briefly explain how knowing the beta of a group of stocks can help investors create a more diversified portfolio. For starters, diversification is not just about investing in different asset classes but investing in different types of assets within those classes. That's where beta can be a very useful measurement.
An unpleasant reality for many investors is thinking they are diversified when they’re not. For example, you can look at two blue-chip stocks. In our example above, we showed the Walt Disney Company with a beta of 1.03. Another blue-chip stock, The Coca-Cola Company has a beta of 0.60. So you can have quite a difference in volatility between two stocks that, based on market cap and other factors, look to be equal.
Using our example above, if an investor was looking for growth; they will want to look at stocks like Microsoft that have a beta above 1. This gives them a greater chance of a higher return for a higher risk of the stock losing value when the market goes down. However, they can hedge this volatility by adding a variety of stocks that are closer to 1 depending on their risk tolerance. Investors who are more active traders may also wish to look at stocks with negative betas if they predict the market is going to go down.
Limitations of beta
As we mentioned above, it’s important to understand what beta is using a benchmark and the timeline that is being measured. If an investor is looking at a mining stock or ETF for example, knowing that it has a negative beta, while helpful, may be somewhat obvious. They may need more information to perform greater fundamental or technical analysis to better assess whether a stock belongs in their portfolio. One way to do this may be to calculate its beta as compared to a precious metals index.
Also, beta does not take into account recent news events that may impact a stock. There are some programs that will calculate a time-varying beta estimate which attempts to take into account factors that affect the characteristics of a company that may affect the way its beta is calculated. However, in general, it would take a significant change over a significant period of time to change a beta in a meaningful way. That's why day traders and other short-term investors will look at other technical cues to decide on whether to invest in a stock.
The final word on beta
Beta is one of the fundamental regression analysis metrics that an investor can use to assess the volatility of a stock compared to a benchmark index such as the S&P 500. Although beta is not used to predict specific price movement, it provides a general sense of how a stock will trend compared to the overall market. Investors with a low-risk tolerance will probably want to have stocks with a beta of 1 or lower. Investors with a higher risk tolerance will want to look at stocks with a beta above 1 because of the potential for a higher return.
Because of its utility as an assessment of volatility, beta is a metric used in both fundamental analysis and technical analysis. Beta can help investors take an objective look at their portfolio and give them direction on how to maintain proper diversification. However, like any metric, beta has its limitations. Investors who are looking for specific indicators will need to look beyond beta to assess if a stock is right for their portfolio.
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