It compares the volatility (risk) of a levered company to the risk of the market. The beta (β) of an investment security (i.e., a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns. Beta helps investors align their investments with their risk tolerance and market outlook.
Beta is a useful number to look at when you want to see whether a stock is likely to move up or down with the market or move in the opposite direction of the market. As a low-priced retailer with a broad range of products, Walmart does a relatively steady business no matter what the prevailing economic conditions are. In fact, its business may pick up when a poor economy leads consumers to seek ways to economize. In this example, the stock has a Beta of 2.0, indicating it is twice as volatile as the market.
Beta (β) is the second letter of the Greek alphabet used in finance to denote the volatility or systematic risk of a security or portfolio compared to the market, usually the S&P 500, which has a beta of 1.0. Stocks with betas higher than 1.0 are interpreted as more volatile than the S&P 500. A security’s β should only be used when its high R-squared value is higher than the benchmark. The R-squared value measures the percentage of variation in the share price of a security that can be explained by movements in the benchmark index. For example, a gold ETF will show a low β and R-squared in relation to a benchmark equity index, as gold is negatively correlated with equities.
What Is Beta in Finance and Stock Markets? Measure, Explained
The beta can even be negative, which would mean that a stock has a negative correlation with the markets. However, over long periods, it isn’t practical for any stock to have a negative beta. Talking of risk, we can broadly divide it into systematic risk and unsystematic risk. As the name suggests, it’s the risk related to the “system,” which in this case is the stock market. Systematic risk is outside the control of the company where you intend to invest. This is also known as a “non-diversifiable risk” since we can’t diversify systematic risk by investing in more than one stock.
For example, geopolitical risk has received a lot of attention after China cracked down on its tech giants. You’ll find this alongside other metrics of a stock’s price when doing your research — which you should always do. Beta can help give investors an idea of the risk in a given stock, and it’s a useful, if incomplete, way of doing so. Any estimates based on past performance do not a guarantee future performance, and prior to making any investment you should discuss your specific investment needs or seek advice from a qualified professional. We are an independent, advertising-supported comparison service.
Investors with low tolerance for volatility would be happy with a stock that has a beta value of 1 or lower. A negative beta correlation would mean an investment that moves in the opposite direction from the stock market. Despite these problems, a historical beta estimator remains an obvious benchmark predictor. It is obtained as the slope of the fitted line from the linear least-squares estimator. The OLS regression can be estimated on 1–5 years worth of daily, weekly or monthly stock returns.
- Including this stock in a portfolio makes it less risky than the same portfolio without the stock.
- The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued.
- The share prices of these companies historically have a tendency to jump around quite a bit.
- It indicates the stock’s volatility compared to that of its peers.
- Obviously if ur using the CAPM to arrive at cost of capital in a situation of the firm having negative beta, ur cost of capital will be lower than ur risk free rate.
Is beta attracted to positive or negative?
They are still stocks, so the market price will be affected by overall stock market trends, even if this does not make sense. A Beta of 1.0 for a stock means it has been as volatile as the broader market. If the index moves up or down 1%, so too would the stock, on average. So if the beta were 1.5 and the index moved up or down 1%, the stock would have moved 1.5%, on average. Betas less than 1.0 indicate less volatility; if the stock had a beta of 0.5, it would have risen or fallen just half a percent as the index moved 1%.
How do I calculate beta?
For every 1% move in the market, Proctor & Gamble’s shares moved 0.42% on average. That’s good in terms of protecting against losses but also means limited upside potential compared to other options. To calculate the beta of a security, the covariance between the return of the security and the return of the market must be known as well as the variance of the market returns.
I.E. some guy who goes out and spends a christmas bonus on gold/guns. This is what makes finding a non-financial/derivative negative beta stock so hard. Obviously if ur using the CAPM to arrive at cost of capital in a situation of the firm having negative beta, ur cost of capital will be lower than ur risk free rate. Think of comparing the beta of different stocks in the same way you might order food at a restaurant. Working with an adviser may come with potential downsides, such as payment of fees (which will reduce returns).
A stock with a very low beta could have smaller price swings, yet still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases the risk in a portfolio only if the investor defines risk strictly in terms of volatility and not potential losses. Investors must ensure that a specific stock is compared to the right benchmark and review the R-squared value relative to the benchmark. R-squared is a statistical measure that compares the security’s historical price movements to the benchmark index. An investor uses beta to gauge how much risk a stock adds to a portfolio.
For example, a gold can beta be negative company with a β of -0.2, which would have returned -2% when the market was up 10%. A beta of 0 means that the security’s price is not correlated with the market movements. In other words, changes in the market have no impact on the security’s price. Beta is based on historical data, meaning it may not accurately predict future performance.
What Beta Means When Considering a Stock’s Risk
Beta values can shift over time because they’re tied to market fluctuations. Investors use beta to align their portfolios with their risk tolerance levels, targeting high-beta stocks for potentially higher returns with more risk or low-beta stocks for added stability. Beta measures how volatile a stock is in relation to the broader stock market over time. A stock with a high beta indicates it’s more volatile than the overall market and can react with dramatic share-price changes amid market swings.
- A beta of 1.0 means the stock over the allocated time frame moved similar to the rest of the market.
- The arbitrage pricing theory (APT) has multiple factors in its model and thus requires multiple betas.
- Also, each particle contains a single negative charge, making the radiation negatively charged.
- Beta effectively describes the activity of a security’s returns as it responds to swings in the market.
- This means beta alone doesn’t give insight into a company’s fundamentals or its potential for future risks.
Beta measures a stock’s volatility, the degree to which its price fluctuates in comparison to the overall stock market. That is a measurement of the stock’s risk compared to that of the greater market. Based on beta analysis, the overall stock market has a beta of 1. And the beta of individual stocks determines how far they deviate from the broader market. Investors often calculate beta by comparing a stock’s price changes to the movements of a benchmark index, such as the S&P 500, throughout a 12-month period. But first let’s understand why it matters, since you can use plenty of free online tools and calculators to compute it yourself.
Beta and Systematic Risk
The stocks of established companies rarely have a beta higher than 4. Beta is also useful when comparing stocks in a sector or industry. It indicates the stock’s volatility compared to that of its peers. The beta is the number that tells the investor how that stock acts compared to all other stocks, or in comparison to the stocks that comprise a relevant index of its peers.
Why is beta used in CAPM?
Past performance can sometimes be a poor indicator of how an asset will behave in the future. Beta can be particularly useful in sector rotation strategies. Different sectors of the economy may have various beta values. During economic cycles, some sectors perform better than others. Investors can use beta to determine which sectors to overweight or underweight in their portfolios, depending on their outlook for the broader market. A more intuitive way of thinking about this is that a negative beta investment represents insurance against some macro economic risk that affects the rest of your portfolio adversely.
Using the previous example, you could expect the stock’s price to go up if the S&P 500 goes down and vice versa. A stock with a beta equal to 1 assumes its price moves hand-in-hand with the market. Thus, negative beta decay results in a daughter nucleus, the proton number (atomic number) of which is one more than its parent but the mass number (total number of neutrons and protons) of which is the same. For example, hydrogen-3 (atomic number 1, mass number 3) decays to helium-3 (atomic number 2, mass number 3).
