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How to use beta when considering stocks
Beta can help you assess risk and volatility but can only account for past performance.
Stock beta is a metric that can help you gauge a stock’s relationship to the overall market. But beta has its limits and should be considered alongside other performance data before an investment decision is made.
What is stock beta?
Stock beta represents a stock’s volatility in relation to the overall market. It’s a number that indicates how much the price of a stock tends to fluctuate compared to other stocks — and the market as a whole. The higher a stock’s beta, the more volatile it is.
Beta is part of the capital asset pricing model (CAPM) — a model that helps investors understand the relationship between an asset’s anticipated return and the risk of investing in that asset.
How does stock beta relate to the broader stock market?
To calculate beta, you need a broad market index, like the S&P 500, to serve as a benchmark. The S&P 500 is typically considered to be representative of US markets. So if you’re interested in the stock beta of an international stock, you’ll need to compare it to a market index from the country the stock is traded.
Index benchmarks help investors understand what type of return the stock is likely to yield in response to market fluctuations that affect that benchmark. In this context, the benchmark has a beta of 1 that operates as the baseline for market volatility. Stock betas that fall below the benchmark tend to be less volatile, while betas above the benchmark tend to be more volatile.
How to calculate stock beta
Stock beta is calculated using regression analysis. The formula for calculating stock beta can be expressed as follows:
Beta = Covariance / Variance
To calculate stock beta, you must have the following information:
- Covariance. The measure of the relationship between two variables — in this case: an asset’s return in relation to the return of the market it’s being compared to.
- Variance. The measure of how the market moves in relation to its mean.
You can find a stock’s covariance by adding the products of differences between the corresponding individual and mean values of the two prices and dividing the sum by the total number of pairs of value.
And you can determine the variance of the index price with the standard statistical variance formula, which takes the differences between each number in a data set and the mean, squares them and divides the sum of the squares by the number of values in the data set.
If financial analysis isn’t your strong suit, don’t panic. Many trading platforms and brokerages have “beta books” — a database of betas for the tradable securities they offer. You can also find beta numbers from third-party research providers, like Yahoo Finance.
What is regression analysis?
Regression analysis is a form of statistical data analysis that can help you understand the relationship that exists between a dependent variable and an independent variable.
For investors trying to understand the level of risk associated with a stock, regression analysis can be used to determine the impact of stock market movement — the independent variable — on the value and potential return of a stock — the dependent variable.
How to analyze stock beta
Understanding a stock’s beta depends on whether it falls above or below the value of 1: this is the benchmark index’s value and the baseline for market volatility. Stocks with a beta of more than 1 tend to be more volatile — think young tech companies on the Nasdaq. Stocks with a beta of less than 1 tend to be less volatile — like stocks in the utility sector. If a stock has a beta of 1, it means that stock moves identically to the overall market.
Beta values represent potential losses and returns. The higher the beta, the more volatile the stock and the higher its return — and its potential for loss. A beta of 2 means that the stock is two times as volatile as the overall market and will see double the return on market gains. But any losses on a stock with a beta of 2 will be amplified twofold. A beta of 0.5 means the stock is half as volatile as the overall market and will only see half the gains of the market on an upswing — but will only lose half as much as the market in the event of a downturn.
To see this in action, let’s look at the gains for stocks with betas of 0.5, 1 and 2 in response to a 15% market upswing:
|Stock||Beta||Return on 15% market upswing|
Now, let’s say instead that the market dropped by 20%. Here are the losses for the same group of stocks:
|Stock||Beta||Loss following 20% market downturn|
Why should I use beta to determine a stock’s volatility?
Beta can help you understand if a stock fits into your investment portfolio. You make this decision based on your overall risk tolerance — that is, how much you’re willing to gamble in the pursuit of a greater return. If you have lower risk tolerance, you may prefer to invest in stocks with lower betas. Investors with greater risk tolerance may be willing to take a chance on stocks with higher betas.
What are the risks of using beta?
Using beta to measure a stock’s volatility can be helpful, but the metric isn’t without its limitations.
First, beta is a historical measure of volatility; it’s not predictive and can’t guarantee stock performance in the future. Second, beta only measures risk and volatility in relation to the market. Beta can help you understand how a stock might behave in the face of market-wide events, but stocks also face internal risks. Beta doesn’t account for this and can’t help you assess company-level risks.
What other factors should I consider when choosing a stock?
You’ll likely need more than beta to assess a stock’s risk. Consider the following factors before you add a stock to your portfolio:
- Time in business. The age of a company factors heavily into the amount of risk associated with investing its stock. The younger the company, the less established and more unpredictably the stock tends to behave.
- Analyst ratings. Reports and ratings from third-party analysts — including those issued by major Wall Street banks, like Goldman Sachs and JPMorgan Chase — can help you gauge the potential risks and benefits of investing in a stock.
- Price/earnings-to-growth ratio (PEG). This figure accounts for a company’s earnings growth and can help you gauge its estimated earnings per share over the next year. Typically, the higher a company’s PEG ratio, the higher its potential growth rate.
- Price-to-book ratio (P/B). The price-to-book ratio divides a company’s stock price by its book value per share to help investors gauge whether a company is undervalued. A low P/B ratio may indicate an undervalued stock.
- Free cash flow. This metric can help you understand how well a business is creating value within the company based on how much net cash is left over after capital expenditures.
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Our expert take
Stock beta can be an important metric in helping you determine a stock’s volatility and risk. But there are other factors to consider before you add a stock to your portfolio, like analyst ratings, time in business, free cash flow and more.
To invest in stocks, you’ll need a brokerage account. Compare your options across multiple platforms to find the account that fits your budget and investment strategy.
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