A beta is used to measure the volatility of a stock. It gauges the securities risk relative to the entire market index.
Betas work by analyzing the performance of the security in the past, then evaluates how the price will likely move in relation to the entire market.
Using betas is a fantastic way to help you gain understanding of the risks with each of your investment securities. After all, you should want to make informed decisions before investing your hard-earned money. Betas are just one of many tools to help you do that.
Why Is Beta Important?
Beta is an indicator of volatility and market risk. While you might not want to fully understand the ins and outs of all things investing because you leave it in the hands of your financial advisor, knowing and understanding betas can help you and your advisor make informed decisions together. It is especially important for those with conservative risk tolerance.
This calculation will provide you with a detailed look of the potential risk associated with the stock. That way, you are not investing in high-risk securities if you tend to invest more conservatively.
What Is It Used for?
A beta is used to measure the expected movement of a stock. It compares the movement relative to the market. This is important for risk tolerance.
People who are younger typically can take more risk than those who are getting closer to retirement. Understanding the beta of each stock will help you make an informed decision on if it is worth adding to your portfolio.
Beta and Market Volatility
Betas are one of the most important measures of volatility for a stock. It provides awareness of how the stock previously performed compared to the market itself. This is a great variable to understand before you add a security to your investment portfolio.
The one thing to note is that while beta tells you if the security is less or more volatile than the market, it does not tell you if it was during bear or bull markets. The measure does not have the ability to distinguish between large upswing or downswing changes.
It also can only provide insight into past metrics. They are not a crystal ball that will tell you the future of the security for a matter of fact.
What Is Beta’s Range?
The measure of betas is based on the figure 1. All markets, such as the S&P 500, have a beta of 1. The individual stocks within each market are then ranked based on how far they deviate from the market.
A stock that has a beta greater than 1 typically indicates that it has a history of being more volatile than the market, but it could also bring about higher returns. If a stock has a beta of less than one, you know it is less volatile than the overall market, which is ideal if you are looking to mitigate risks within your portfolio.
When a company stock has a high beta, that means that the beta is greater than 1. If you invest in a high-risk company with a beta of 1.75, it will mean that the stock has returned 175% of what the overall market returned within the set period.
A beta of zero is riskless and uncorrelated to the market index. What this means is that the security does not fluctuate based on the overall market.
When a company stock has a low beta, that means that it is less than 1. If you invest in a low-risk company with a beta of 0.55, it will mean that the stock has returned 55% of what the overall market returned within the set period.
When a company stock has a negative beta, that means that it has a negative return. For example, if a stock has a beta of -0.2, that means when the market went up 10%, it had a return of -2%.
Example of Beta
Amazon.com has a 1.13 beta. This indicates that investors can expect 113% of what the overall market returns.
On the other hand, Johnson & Johns has a beta of only 0.7. This means that for every 1% the market moves, it will only move 0.7%.
How To Calculate Beta
Calculating beta is a formula that is as follows:
Beta = Covariance / Variance
This formula should be done within a spreadsheet. After you have opened Excel or Google Sheets, you will need to:
- Obtain the daily stock closing price over a set period of time
- Obtain daily closing price for the benchmark market index over the same period
- Calculate the daily price changes for your selected stock
- Calculate the daily price changes for the market index
- Compare how the stock price has moved relative to the market index
A covariance is a tool that helps determine the relationship between the movement of two prices. When calculating a beta, you are determining the relationship between your stock and the market index.
A variance is the measurement of a spread between numbers within a set of data.
Variance is calculated by taking the difference between each of the numbers within the data set, then making them positive by squaring them. Finally, you divide the sum of those squares by the value of the numbers within the data set.
Using Beta to Make Investment Decisions
The variability of a stock’s price is important when you are trying to assess risk. Betas are a great tool to help you guide the diversification of your portfolio. Another great tool you should consider utilizing is the expertise of a financial advisor.
Your financial advisor will help assess your personal risk tolerance, then provide investment strategies based on beta analysis and the risk tolerance they assessed. They will use beta as just one of many strategies and tools in their arsenal to help you get the most out of your future financial wealth.