Beta (β) measures the sensitivity or volatility of the stock relative to the fluctuations in the overall stock market. A stock is considered more volatile (with volatility higher than S&P 500) if its beta is higher than 1.0.
Beta is an important parameter in the capital asset pricing model (CAPM). The CAPM model relates the systematic risk and expected return for assets. It helps in the pricing the risky securities. Moreover, it also assesses the estimates of the expected returns of assets while considering the capital cost and risk of those assets.
Beta: How Does It Work?
A beta coefficient is a measure of stock volatility in comparison to the systematic risk of the entire market. Statistically, the slope of the line through regression of data points represents beta. These data points refer to the return of an individual stock compared to the overall market.
Beta is also a standard for describing the activity of a security's returns in response to market swings. The security's beta can be obtained by multiplying the market's returns and the covariance of the security's returns and then dividing this product by the variance of the market's returns.
Finally, a stock's beta is used by an investor to determine how much risk it adds to its portfolio. A stock with little variation from the market is less risky to the portfolio. Moreover, it also reduces the potential for greater returns.
A stock should have a strong R-squared value concerning the benchmark to ensure that it is being compared to the appropriate benchmark. R-squared is a statistical metric that indicates historical price movements in a security, which could be further explained based on the movements in the benchmark index. When determining the level of systematic risk using the beta, a security with a high R-squared value with respect to its benchmark may suggest a more appropriate benchmark.
A stock investor may divide risk into two categories. Systematic risk is the first category that describes the risk of declining the entire market. An example of a systematic risk event is the financial crisis of 2008. Investors' stock portfolios lost value despite their best efforts at diversification. Un-diversifiable risk is another name for systematic risk.
Unsystematic risk sometimes referred to as diversifiable risk, is the unpredictability connected to a specific stock or sector. Diversification can reduce unsystematic risk in some cases.
Types of Beta Values
Beta Value Less Than One
Security is theoretically less volatile than the market if its beta value is less than 1.0. A portfolio with this stock is less risky than the same portfolio without it. Since utility stocks move more slowly than the market averages, they potentially have low betas.
Beta Value Equal to 1.0
A stock's price movement is highly connected with the market if its beta value is 1.0. Systematic risk exists for stocks with a beta value of 1. However, the beta calculation doesn't help in identifying the unsystematic risk. A stock with a beta of 1.0 can be added to a portfolio without necessarily increasing risk or the potential for higher returns.
Beta Value Greater Than One
A beta value greater than 1.0 indicates the highly volatile nature of the security's price. For instance, a stock is thought to be 20% more volatile than the market if its beta is 1.2. Small-cap and technology stocks frequently have betas larger than the market benchmark. Adding stock to a portfolio will raise the portfolio's risk and potential for return.
Negative Beta Value
Negative betas also exist. For instance, a stock with a -1.0 beta value indicates an inverse relationship between the stock and market benchmark. There is the possibility that stocks and benchmark trends are mirror images of each other. Inverse ETFs and Put options have negative beta values. Additionally, a few industry groups, such as gold miners, frequently have negative betas.
What Is a Good Beta for a Stock?
Beta value is a measure of the volatility and riskiness of a stock. Therefore, a good beta will depend on your goals and risk tolerance potential. For instance, a beta value of 1.0 is ideal if you want to replicate the broader market in your portfolio. Conversely, a lower beta value will be more suitable if you want to preserve the principal. A beta value higher than 1.0 in the bull market will produce above-average returns and more losses in the down market.
Limitations of Beta
A beta is a useful tool for stock evaluation. For instance, when utilizing the capital asset pricing model (CAPM) to calculate equity costs, beta is important for examining volatility and evaluating the short-term risk of a security.
However, it has some limitations as well. For instance:
● It is challenging to identify the future movements of a stock based on the beta value because beta is based on historical data points.
● It is not useful for long-term investments because of fluctuations in stock volatility.
● It is an unreliable measure because stocks can potentially jump around over time.