Instead, negative beta means your investment offers a hedge against serious market downturns. Beta (β) is the second letter of the Greek alphabet used to measure the volatility of a security or portfolio compared to the S&P 500, which has a beta of 1.0. A Beta of 1.0 shows that a stock has been as volatile as the broader market. Betas larger than 1.0 indicate greater volatility, and betas less than 1.0 indicate less volatility.
- However, this could also mean it has the potential for stronger returns.
- Furthermore, even assets that, in theory, could have negative betas (gold, for instance) seem to have positive betas when securitized (gold shares, gold ETF).
- It does not measure the risk when an investment is held on a stand-alone basis.
- As they have a small mass and can be released with high energy, they can reach relativistic speeds (close to the speed of light).
- Investors who are very risk-averse should put their money into assets with low betas, such as utility stocks and bonds or Treasury bills.
- The covariance of the return of an asset with the return of the benchmark is divided by the variance of the return of the benchmark over a certain period.
To get the most out of a good beta calculation, that benchmark must be as related to the stock as possible. However, in the world of investing, things are rarely black and white. Beta is based on historical data, and past performance doesn’t guarantee future outcomes.
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. Many young technology companies that trade on the Nasdaq stocks can beta be negative have a beta greater than 1. This suggests that it acts independently of the overall stock market. Beta particles have a mass which is half of one thousandth of the mass of a proton and carry either a single negative (electron) or positive (positron) charge. As they have a small mass and can be released with high energy, they can reach relativistic speeds (close to the speed of light).
Q. How is Beta used in the Capital Asset Pricing Model (CAPM)?
It can be read as a straightforward indicator of its price volatility in comparison with the stock market at large and in comparison with its peers. A very conservative investor might avoid any stock with a beta of more than 1, as it could indicate an unacceptable degree of risk. Essentially, beta expresses the trade-off between minimizing risk and maximizing return. On the other hand, if the market declines by 6%, investors can expect a loss of 12%.
How to calculate beta
- For example, the Great Recession was a form of systematic risk.
- Beta (β) is the second letter of the Greek alphabet used to measure the volatility of a security or portfolio compared to the S&P 500, which has a beta of 1.0.
- Beta is also useful when comparing stocks in a sector or industry.
- A stock’s price variability is important to consider when assessing risk.
While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns. Beta is a measure that reflects how strongly a stock’s price tends to move in relation to the broader market’s movements. It helps investors estimate how much a stock might amplify or dampen the market’s ups and downs when added to a portfolio. A beta value of 1.5 implies that the stock is 50% more volatile than the broader market.
Another troubling factor is that past price movement is a poor predictor of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead. Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable.
Using beta to evaluate a stock’s risk
Other factors, such as our own proprietary website rules and whether a product is offered in your area or at your self-selected credit score range, can also impact how and where products appear on this site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. Beta allows for a good comparison between an individual stock and a market-tracking index fund, but it doesn’t offer a complete portrait of a stock’s risk. Instead, it’s a look at its level of volatility, and it’s important to note that volatility can be both good and bad. The downward price movement, of course, will keep people up at night. Remember, beta measures how volatile a stock’s price may be in relation to a market benchmark.
Analysts use beta when they want to determine a stock’s risk profile. A company behind the next big thing typically commands a high valuation. Investors buy the stock based on it living up to its potential, which requires lots of uncertain factors going its way. A slip-up could result in the share price tumbling dramatically. Likewise, a small hint of good news can lead to another big rally.
How Investors Use Beta
Beta can be a useful metric to determine how a stock’s price may move in relation to the overall market by examining its past performance. It can also be a useful indicator of risk, especially for investors who make trades frequently. It doesn’t account for how companies may undergo major changes in the future, for example. Still, it serves as one of many useful factors you can weigh when making investment decisions. Beta is the hedge ratio of an investment with respect to the stock market. For example, to hedge out the market-risk of a stock with a market beta of 2.0, an investor would short $2,000 in the stock market for every $1,000 invested in the stock.
Estimators of market-beta have to wrestle with two important problems. First, the underlying market betas are known to move over time. Second, investors are interested in the best forecast of the true prevailing beta most indicative of the most likely future beta realization and not in the historical market-beta.
High-beta stocks are supposed to be riskier but provide higher return potential. Conversely, low-beta stocks pose less risk but also offer lower potential returns. Beta is a component of the capital asset pricing model (CAPM), which is widely used to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. Note that beta can also be calculated by running a linear regression on a stock’s returns compared to the market using the capital asset pricing model (CAPM). Levered beta includes both business risk and the risk that comes from taking on debt.
A stock that swings more than the market over time has a beta above 1.0. Stocks that have a low beta, such as consumer staples, are often used to hedge a portfolio of higher-beta stocks. These low-beta stocks are relatively unaffected by the market’s gyrations or even benefit in times when the economy is poor. Investors can still try to minimize the level of exposure to systematic risk by looking at a stock’s beta, or its correlation of price movements to the broader market as a whole. Diversification cannot help an investor to smooth out systematic risk, given that it affects all or most industries.
What is the difference between the beta of a portfolio and a benchmark?
But broadly speaking, the notion of beta is fairly straightforward. It’s a convenient measure that can be used to calculate the costs of equity used in a valuation method. A low-beta stock is in a company or industry that is perceived as less sensitive to the factors that affect stock prices in general or is even likely to move in the opposite direction. Once you’ve calculated the beta of a stock, it can then be used to tell you the relative correspondence of price movements in that stock, given the price movements in the broader market as a whole. High β – A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market returned in a given period (typically measured weekly).
In portfolio management, beta is used to construct a portfolio that matches the investor’s risk tolerance. By combining securities with different betas, a portfolio’s overall risk can be managed. A stock with a high Beta is expected to show larger price fluctuations. Investors can predict how an asset will behave in different market conditions, allowing them to adjust their strategy accordingly. Some of these risks are at the forefront in the current markets.
Anything that can affect the market as a whole, good or bad, is likely to affect a high-beta stock. A Federal Reserve decision on interest rates, a tick up or down in the unemployment rate, or a sudden change in the price of oil, all can move the stock market as a whole. This can be achieved by obtaining other stocks that have negative or low betas, or by using derivatives to limit downside losses. Systematic risk, or total market risk, is price volatility that affects stocks across many industries, sectors, and asset classes. Risks that affect the overall market are by their nature difficult to predict and hedge against. Let’s say the beta value of the entire stock market, as measured by an index, is 1.
This means beta alone doesn’t give insight into a company’s fundamentals or its potential for future risks. Understanding beta can be a valuable tool when building your investment portfolio. For those with a low risk tolerance, focusing on stocks with betas between 0 and 1 may align better with your financial goals. These stocks tend to be less volatile than the broader market, which can offer more stability.