We often hear the word beta in the context of “beta test”. It’s a way of testing something (e.g. a software program) in a real-world situation to iron out any glitches before rolling it out to the public.
In the context of investing, understanding beta also serves a predictive function. Specifically, knowing a stock’s beta can help investors understand why a company may be performing or underperforming. In this way, beta can help investors predict how a stock is likely to perform before they buy the stock.
This article will define beta and key terms to help investors understand beta. We’ll also review the difference between provided beta and personally calculated beta, what beta indicates, and how to use beta to diversify a portfolio. And finally, we’ll look at a couple of limitations to beta.
Beta is a Measurement of Volatility That Supports Fundamental and Technical Indicators
Beta measures the relative volatility of a stock in correlation to a particular standard. For U.S. stocks that standard is usually, but not always, the S&P 500. Beta can also be used by investors to evaluate a particular stock’s expected rate of return, particularly when using the Capital Asset Pricing Model (CAMP).
Beta is a form of regression analysis and it can be useful for investors regardless of their risk tolerance. Beta is considered one of the few data points that can be beneficial for practitioners of fundamental analysis and technical analysis. Investors who tend to analyze stocks using fundamental analysis will use beta along with price-to-earnings ratio, shareholders equity, debt-to-equity ratio and other factors. Technical analysts will use beta as an indicator of stocks that offer the price movement they are seeking. They will use beta along with other indicators such as average daily trading volume (ADTV) and a stock’s moving average.
What is the Formula for Calculating Beta?
Investing websites like MarketBeat give investors access to many company’s financial metrics. This means that investors do not typically need to calculate beta for themselves. But it’s still helpful to understand the meaning of two variables that are used in the formula for beta. These variables are covariance and variance.
- Covariance is a measurement of how two stocks move together. If the number is positive it means the price movement is generally correlated (i.e. when one stock goes up, so does the other and vice versa). If the number is negative, it means the price movement is generally not correlated (i.e. when one stock goes up, the other goes down and vice versa).
- Variance is a measurement of how far a stock moves in relation to its mean. In the case of beta, the mean is whatever benchmark is being used.
With that in mind, Beta is found by dividing covariance by variance. A financial advisor—or any investor, really—can leverage the beta calculation to measure individual stocks in terms of risk, relative to the stock market, or even a more specific index or fund, such as the securities in exchange-traded funds or a portfolio of stocks.
An investment advisor (or formula-savvy retail investor) can then leverage the beta calculation again to build a capital asset pricing model. This more complex formula provides mathematically-backed investment advice about the risk of individual stocks relative to their expected rate of return.
Investors can then build an investment strategy to reduce risk and acquire an asset that will outperform the market—minimizing losses and increasing gains.
Individual investors who are active traders will also want to make sure they do their own beta calculation to assess risk and build a CAPM to assess potential gains. Though it’s not the only stat they need to formulate a strategy, it’s as important as any of the other ones, such as market capitalization and price.
What Are the Variables in “Provided Beta” Calculations?
In many cases, a financial website will give what’s known as the “provided beta” for a particular stock. For active traders, financial software programs will also provide the beta value. When using a provided beta, investors should pay attention to two variables.
First, it’s important to understand what benchmark is being used to determine beta. Since the beta shows a correlation between a particular security and something, an investor needs to know what that something is. As pointed out above, for U.S. stocks it is common for beta to be expressed as a correlation to a stock index, usually the S&P 500, but not always. In some cases, the Dow Jones Industrial Average (DJIA) may be used, or even the NASDAQ.
The second thing an investor will need to know about a stock’s beta is the time frame that is being measured. If you’re a long-term investor, you may want to know the beta over several years. If you’re an active trader, you’ll probably be more interested in the beta over a much more recent timeframe.
A personally calculated beta, on the other hand, is one that investors will calculate for themselves. To calculate beta, investors will have to know the covariance between the return of the stock being analyzed and the return of the benchmark for that stock as well as the variance of the market returns.
As we mentioned above, many financial software programs will do the calculation for you. It is also possible to use an Excel spreadsheet to calculate beta. For many investors, particularly those who are engaging in day trading, a personally calculated beta may be more accurate for their needs.
Beta Defines a Stock’s Volatility Relative to its Benchmark Index
Beta can get confusing if an investor gets hung up on positive and negative. When an investor sees a negative number, they instinctively think a stock is falling (i.e. generating a negative return). That is not necessarily the case with a negative beta. Here’s why:
As we defined it above, beta is a correlation between the price movement of a security and a benchmark related to that security. Beta is a multiplicative factor. So a beta of 1.3 means that a stock is 30% more volatile than the broader stock market.
For these examples, let’s assume an investor is buying a U.S. stock that is being benchmarked to the S&P 500. The beta of the S&P 500 is 1. The simplest explanation for this is that in establishing a benchmark, you’re dividing one thing by itself and that will always equal 1.
So knowing the beta of the S&P 500 is 1, here’s how investors can interpret the beta of a particular stock:
- Beta of 1 – this means a stock is highly correlated to the S&P 500. Therefore, if the S&P 500 index is up for the day, the stock is more than likely going to be up for the day and vice versa. A beta of 1 also means that price movement will probably be very similar. In other words, if you were to overlay the stock’s price movement over the S&P 500, the two lines would look very similar.
- Beta of less than 1 – this means a stock is not very correlated with the market. Sometimes it will follow the trend in the market, but sometimes it won’t. In terms of price movement, a beta of less than 1 is indicating that the stock is less volatile (i.e. less reactive to price movements in the broader market).
- Beta of more than 1 – this also means a stock is not very correlated to the market. However, unlike a beta of less than 1, this means a stock is highly volatile (i.e. more reactive to price movements in the broader market).
- Beta of less than 0 (i.e. a negative beta) – this means a stock is inversely correlated to the market. The tendency of the stock is to move in the opposite direction as the market. The higher the negative number, the more volatile the stock.
The key thing to know about beta is its relationship to the number 1. The closer the number is to 1, the more it is correlated to the market; the further it is from 1, the less it is correlated. A beta can also be much higher than 1. There are some stocks that can have a beta of 2 or more.
Let’s go through some examples as of July 21, 2022:
- Microsoft (NASDAQ: MSFT) has a beta of 0.93. This puts its volatility right in line with the broader market. This is what you might expect from a blue-chip stock.
- Walt Disney Company (NYSE: DIS) has a beta of 1.24. This means an investor can reasonably expect that this stock is 25% more volatile than the market.
- Advanced Micro Devices (NASDAQ: AMD) has a beta of 1.96. This means the stock price has almost twice the volatility of the market.
- In contrast, Duke Energy (NYSE: DUK) has a beta of around 0.35. This means it is not a very volatile stock, which is what investors would expect from a utility stock. However, this doesn’t mean that the stock is underperforming.
This brings to mind a third, and perhaps the most important thing to know about beta. Beta measures potential volatility, not price performance. A positive beta does not mean that a stock is going up in price. In fact, a stock that has a high beta while the market is falling is more than likely falling at a higher percentage rate than the market.
Likewise, a negative beta does not mean that a stock is going down in price. When the market is trending lower, these stocks will tend to rise. A negative beta also does not mean that a company is underperforming. It just the the company operates in a sector that will naturally work in opposition to the broader market. Stocks of gold mining companies and gold ETFs are a good example of this. You would expect these stocks to have a negative beta compared to the market because gold (and many other precious metals) tend to rise when the market falls and vice versa.
How to Use Beta for Diversification
How can knowing the beta help investors create a more diversified portfolio? For starters, diversification is not just about investing in different asset classes. It's about investing in different types of assets within those classes. This is where beta can be a very useful measurement.
Many investors think they are diversified when they’re actually not. For example, two blue-chip stocks can have quite a difference in beta. This will affect the expectations of stock performance even though, based on market cap and other factors, the stocks look to be equal.
Using our example above, if an investor is looking for growth, they will want to look at stocks that have a beta above 1. This gives them a greater chance of a higher return for a higher risk of the stock losing value when the market goes down. However, they can hedge this volatility by adding a variety of stocks that are closer to 1, depending on their risk tolerance. Investors who are more active traders may also wish to look at stocks with negative betas if they predict the market will go down.
What are the Limitations to Using Beta?
As we mentioned above, it’s important to understand what beta is using as a benchmark and the timeline that is being measured. If an investor is looking at a mining stock or ETF for example, knowing that it has a negative beta, while helpful, may be somewhat obvious. An investor may need more information to perform greater fundamental or technical analysis to better assess whether a stock belongs in their portfolio. One way to do this may be to calculate its beta as compared to a precious metals index.
Also, beta does not take into account recent news events that may impact a stock. There are some programs that will calculate a time-varying beta estimate which attempts to take into account factors that affect the characteristics of a company that may affect the way its beta is calculated. However, in general, it would take a significant change over a significant period of time to change a beta in a meaningful way. That's why day traders and other short-term investors will look at other technical cues to decide on whether to invest in a stock.
Risks of High Beta Stocks
High beta stocks do carry some risks. Stocks with high betas are more volatile in comparison to the overall market or index. Beta actually says nothing about the direction of a stock’s momentum in price, or the relative strength of the company.
If a stock price is ballooning beyond the pace of the market, the company may be overvalued. Eventually, that bubble will pop, leaving investors with great losses. Smart investors and traders do not ride waves of hype. Conversely, a high beta stock may be from a company whose stock price is plummeting due to some current events that might have a longstanding negative impact, such as downsizing or bankruptcy.
High beta stocks may indicate a history of frequent movement in opposition to the overall stock market. These types of stocks are generally volatile and can throw off investors who do not have experience riding market waves—that is, knowing when to buy and sell. If an investor is involved with active trading and prefers to minimize their risk, they can also balance out their trading with some low beta stocks. These less-volatile securities can stabilize their portfolio of stocks by compensating for some of the losses incurred by high beta stocks that deviate from an expected return.
A smart beta strategy can be used to minimize the risk impact of high beta stocks. This type of strategy might combine something passive and more stable, like a dividend investing strategy, with active trading in order to minimize losses from the most volatile stocks in the fund.
Why Invest in High Beta Stocks?
Investors working with high beta stocks are hoping to cash out on the stock price waves, buying low and selling high. They may have scoured lists of cheap stocks to buy or stock market gainers in their search for potential profits, but if they’re playing a short game like day trading, finding stocks with the most momentum can provide an easy entry and exit strategy to cash out on the same day.
Beta only provides information about the momentum of individual stocks in relation to the stock market. It is not an indicator of future or past performance.
However, high beta stocks will have price swings that can lead to great gains, if bought and sold appropriately. It’s important for active traders using the beta calculation (and other stats) to consider the alpha and beta of a stock—the former being an indicator of how much return a stock historically provides relative to its risk.
Of course, investors looking for the most stable investments will want to look at a capital asset like rental property, treasury bills, or mutual funds—avoiding high beta stocks, or even the whole process of analyzing beta and calculating risk as they buy and sell securities. But while these investment strategies can minimize losses, they don’t fund great gains, either. Investors who want steady gains but minimal risk should consider looking into securities that generate dividends.
Some Final Thoughts on Beta
Beta is one of the fundamental regression analysis metrics that an investor can use to assess the volatility of a stock compared to a benchmark index such as the S&P 500. Although beta is not used to predict specific price movement, it provides a general sense of how a stock will trend compared to the overall market.
- Investors with a low risk tolerance will probably want to have stocks with lower betas (i.e. 1 or lower).
- Investors with a higher risk tolerance will want to look at stocks with high beta values because of the potential for high returns.
- Investors who are not interested in cashing out on a risk-reward relationship might explore other options, such as the best growth stocks. But even then, the best high beta stocks can provide a forecast of how volatile it will be in the future—and in turn, build a capital asset pricing model to determine potential reward.
Because of its utility as an assessment of volatility, beta is a metric used in both fundamental analysis and technical analysis. Beta can help investors take an objective look at their portfolio and give them direction on how to maintain proper diversification. However, like any metric, beta has its limitations. Investors who are looking for specific indicators of future results will need to look beyond beta to assess if a stock is right for their portfolio.