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.

The value of any stock index, such as the Standard & Poor’s 500 Index, moves up and down constantly. At the end of the trading day, we conclude that “the markets” were up or down. An investor considering buying a particular stock may want to know whether that stock moves up and down just as sharply as stocks in general. It may be inclined to hold its value on a bad day or get stuck in a rut when most stocks are rising.

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.

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.

Investment analysts use the Greek letter ‘ß’ to represent 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.

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.

Here is a basic guide to beta levels:

• 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.

Are you prepared to take a loss on your investments? Many people are not and they opt for investments with low volatility. Others are willing to take on additional risk for the chance of increased rewards. Every investor needs to have a good understanding of their own risk tolerance, and a knowledge of which investments match their risk preferences.

Using beta to understand a security’s volatility can help you choose those 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.

Many brokerage firms calculate the betas of securities they trade and then publish their calculations in a beta book. These books offer estimates of the beta for almost any publicly traded company.

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.)

The biggest drawback to using beta to make an investment decision is that beta is a historical measure of a stock’s volatility. It can show you the pattern so far but it can’t tell you what’s going to happen in the future.

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 towards 1 and lower betas tend to rise towards 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.