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Using Beta To Understand A Stock's Risk
Using Beta To Understand A Stock's Risk
In investing, beta does not refer to fraternities, product testing, or old videocassettes. Beta is
a measurement of market risk or volatility. That is, it indicates how much the price of a stock
tends to fluctuate up and down compared to other stocks.
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The beta is the number that tells the investor how that stock acts compared to all other
stocks, or at least in comparison to the stocks that comprise a relevant index.
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KEY TAKEAWAYS
The beta indicates how volatile a stock's price is in comparison to stocks in general.
A beta greater than 1 indicates a stock's price swings more wildly than most stocks.
A beta of 1 or lower indicates that a stock's price is steadier than most stocks.
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the
overall stock market. In other words, it gives a sense of the stock's risk compared to that of
the greater market's.
Beta is used also to compare a stock's market risk to that of other stocks.
Analyzing Beta
Beta is calculated using regression analysis. A beta of 1 indicates that the security's price
tends to move with the market. A beta greater than 1 indicates that the security's price tends
to be more volatile than the market. A beta of less than 1 means it tends to be less volatile
than the market.
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Many young technology companies that trade on the Nasdaq stocks have a beta greater than
1. Many utility sector stocks have a beta of less than 1.
Essentially, beta expresses the tradeoff between minimizing risk and maximizing return. Say
a company has a beta of 2. This means it is two times as volatile as the overall market. We
expect the market overall to go up by 10%. That means this stock could rise by 20%. On the
other hand, if the market declines 6%, investors in that company can expect a loss of 12%.
If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: A market
return of 10% would mean a 5% gain for the company.
Negative beta. A beta less than 0, which would indicate an inverse relation to the market,
is possible but highly unlikely. Some investors argue that gold and gold stocks should
have negative betas because they tend to do better when the stock market declines.
Beta of 0. Basically, cash has a beta of 0. In other words, regardless of which way the
market moves, the value of cash remains unchanged (given no inflation).
Beta between 0 and 1. Companies with volatilities lower than the market have a beta of
less than 1 but more than 0. Many utility companies fall in this range.
Beta of 1. A beta of 1 means a stock mirrors the volatility of whatever index is used to
represent the overall market. If a stock has a beta of 1, it will move in the same direction
as the index, by about the same amount. An index fund that mirrors the S&P 500 will have
a beta close to 1.
Beta greater than 1. This denotes a volatility that is greater than the broad-based index.
Many new technology companies have a beta higher than 1.
Beta greater than 100. This is impossible, as it indicates volatility that is 100 times greater
than the market. If a stock had a beta of 100, it would go to 0 on any decline in the stock
market. If you see a beta of over 100 on a research site it is usually a statistical error or the
stock has experienced a wild and probably fatal price swing. For the most part, stocks of
established companies rarely have a beta higher than 4.
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Important: Using beta to understand a security's volatility can help you choose
the securities that meet your criteria for risk.
Investors who are very risk averse should put their money into assets with low betas, such as
utility stocks and Treasury bills. Investors who are willing to take on more risk may want to
invest in stocks with higher betas.
Yahoo! Finance is among the websites that publish beta numbers. Enter the company name
or symbol in the search field, then click on Statistics. You'll find the beta listed under Stock
Price History. The beta on Yahoo! compares the activity of the stock over the last five years to
that of the S&P 500 Index. (A beta of "0.00" means that the stock is either a new issue or
doesn't yet have a beta calculated for it.)
One study by Gene Fama and Ken French, "The Cross-Section of Expected Stock Returns,"
published in 1992 in the Journal of Finance, concluded that past beta is not a good predictor
of future beta for stocks. In fact, they concluded, betas seem to revert back to the mean over
time. This means that higher betas tend to fall back toward 1 and lower betas tend to rise
toward 1.
The second caveat for using beta is that it is a measure of systematic risk, which is the risk
that the market faces as a whole. The market index to which a stock is being compared is
affected by market-wide risks. So, beta can only take into account the effects of market-wide
risks on the stock. The other risks the company faces are specific to the company.
Related Articles
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INVESTING ESSENTIALS
Vive La Différence -- What Is The Difference Between
Alpha And Beta?
MUTUAL FUNDS
What metrics do I use to evaluate the risk-return tradeoff
for a mutual fund?
FINANCIAL RATIOS
The Formula for Calculating Beta
RISK MANAGEMENT
How does Beta reflect systematic risk?
Partner Links
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Related Terms
Understanding Beta and How to Calculate It
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. Beta is used in the capital asset pricing model (CAPM). more
R-Squared
R-squared is a statistical measure that represents the proportion of the variance for a dependent
variable that's explained by an independent variable. more
TRUSTe
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