Beta (β) is a measure of volatility or systemic risk. It is also called the beta coefficient.
The β of an investment security such as a stock refers to a volatility measurement surrounding that stock’s returns relative to a market (i.e., the S&P 500) or an alternative benchmark.
A beta of 1 indicates a share that generally moves in line with the market. A beta of 1.2 implies that the share should rise 12% for each 10% rise in the market and fall 12% for each 10% decline in the market.
When beta comes in below one but above zero, it is considered a safer choice in a down market. That’s because the individual share price should fall less rapidly than the stock market overall. Conversely, low beta stocks are also more likely to underperform a rising stock market.
The beta changes over time and is influenced by the degree of operational and financial gearing a company has. That’s because debt affects the volatility of profits.
A rule of thumb is that defensive stocks tend to be low beta, while cyclical stocks with a higher likelihood of debt have a high beta.
How Beta works
Beta is principally used in the capital asset pricing model (CAPM). This is a model widely used in finance as a way to price risky securities and gauge expected returns.
To ensure beta is meaningful, the stock must be correlated to the benchmark being used in the calculation.
A beta coefficient is used to measure the volatility of an individual stock in comparison with the wider stock market.
In statistics, beta values are the standardized regression coefficients. Beta is represented by the slope of a line in linear regression analysis.
Types of Beta
High Beta (β): A stock with high beta has greater risk along with greater expected returns. For instance, a high-risk oil company with a β of 1.8 would have returned 180% of the returns the correlated market achieved in a specified period.
Low Beta (β): A stock with low beta has reduced risk along with lower expected returns. A utility company is an example of a consistent but unexciting stock investment. For instance, a stock with a beta of 0.3 would have returned 30% of the correlated market return during the period.
Negative Beta (β): A stock with negative beta is negatively correlated with the returns of the wider stock market. For instance, a mining company with a β of -0.3 would have returned -3% when the wider market was up 10%.
Examples of beta charts for Apple (NASDAQ: AAPL) and Tesla (NASDAQ: TSLA):
- When β = 1 this means stock volatility is in line with the wider stock market
- β > 1 means stock is more volatile than the wider stock market
- When β <1> 0, it means the stock is less volatile than the wider stock market
- β = 0 means stock volatility is uncorrelated to the wider stock market
- β < 0 means stock volatility is negatively correlated to the wider stock market
In asset pricing theory, beta represents the type of systemic risk that can’t be diversified away.
Some examples of beta
A beta of 1.2 will move, on average, 1.2 times the market return. Therefore, if the market returns 10%, a stock with a beta of 1.2 will return 12%.
A beta of 1.3 will move, on average, 50% more than the market return. Therefore, if the market returns 10%, a stock with a beta of 1.3 will return 13%.
A beta of 1.5 will move, on average, 1.5 times the market return. Therefore, if the market returns 10%, a stock with a beta of 1.5 will return 15%.
A beta of 1.7 will move, on average, 70% greater than the market return. Therefore, if the market returns 10%, a stock with a beta of 1.7 will return 17%.
A beta of 2 means a stock could potentially turn twice the market average. So, if the S&P 500 returns 5%, the stock with the beta of 2 in relation to the S&P 500 should return 10%.
Advantages of Beta
Beta can give an investor an approximate idea of the risk a stock will add to a diversified portfolio.
Day traders like high beta stocks because they offer much higher risk-reward. Beta is also useful for gauging a stock’s volatility in relation to the overall stock market.
Disadvantages of Beta
Beta is simply a tool that financial analysts can use to evaluate portfolio risk. However, it has its limits and is not infallible.
A stock can have zero beta and higher volatility than the market. The Beta is likely to change over time.
Beta’s may differ depending on the market direction. For instance, a beta may be greater for a down move in the market than it is for an up move.
The estimated beta may be biased if the stock is not frequently traded.
Financial markets are prone to surprises where returns don’t follow a pattern of normal distribution. This limits the success of beta at predicting stock movements.
Beta is based on historical data and therefore cannot be relied on to predict future price movements.
Where’s the value?
- Analysts use beta as a measure to determine a stock’s risk profile.
- Beta is the measure of systemic risk of an equity or portfolio compared to the relevant market.
- Traders find beta strategies useful in limiting downside risk or realizing short-term gains.