How to use beta to evaluate a stock’s risk
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When you invest, be prepared to encounter bumps along the way. The stock market moves up and down all the time, but the individual stocks that comprise the market all move at different paces. Some might have higher highs and lower lows, and others might move in nearly identical fashion to the market as a whole. Will a stock feel like a roller-coaster ride? Or will it feel more like you’re driving on a highway at the same pace as the car next to you?
Investors have developed a way to tell: It’s called beta, and it can offer helpful clues.
What is beta, and how does it work?
Beta is a way of measuring a stock’s volatility compared with the overall market’s volatility. By definition, the market as a whole has a beta of 1, and everything else is defined in relation to that:
- Stocks with a value greater than 1 are more volatile than the market, meaning they will generally go up more than the market goes up, and go down more than the market goes down.
- Stocks with a beta of less than 1 have a smoother ride as their moves are more muted than the market’s, but they’ll usually still go up when the market goes up and down when the market goes down.
- Securities with a negative beta, which is unusual, will typically move inversely to the market. So when the market goes up, these securities fall, and vice versa.
To calculate beta, investors divide the covariance of an individual stock (say, Apple) with the overall market, often represented by the Standard & Poor’s 500 Index, by the variance of the market’s returns compared to its average return. Covariance is a measure of how two securities move in relation to one another.
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.
Using beta to evaluate a stock’s risk
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 good and bad. Investors aren’t complaining about upward price movements. The downward price movement, of course, will keep people up at night.
Think of comparing the beta of different stocks in the same way you might order food at a restaurant. If you are a more risk-averse investor who is focused on earning income, you might shy away from high-beta stocks the same way that someone with a simpler palate might prefer to order a plain dish with familiar ingredients and flavors. A more aggressive investor with a higher risk tolerance might be more inclined to chase the high-beta stocks the same way an adventurous eater will look for new, spicy dishes with exotic ingredients they have never tried.
Beta is a data point that is widely available. You’ll find this alongside other metrics of a stock’s price when doing your research — which you should always do.
Pros and cons of using beta
- History can hold important lessons: Beta uses a sizable chunk of data. Typically reflecting at least 36 months of measurements, beta gives you an idea of how the stock has moved vs. the market over the last three years.
- Numbers don’t lie: Rather than combing through press releases about past product launches or trying to read between the lines of what a company’s CEO might have said at the investor day last year, and how the stock reacted to these various pieces of news, beta mathematically represents the stock’s moves for you.
- You’re looking in the rearview mirror: Beta is a backward-looking, singular measure that doesn’t incorporate any other information. Sure, it’s good to reflect on what the past three years looked like, but as an investor, what you care about is what’s in store for the next three years. You want to think about business prospects and potential market disruptions on the horizon. That’s why beta is only one part of your research.
- Numbers aren’t everything: Beta doesn’t include qualitative factors that can play a significant role in a company’s outlook. Did that renowned CEO step down during those three years? Now that the succession plan is in place, perhaps the future will look quite a bit different.
- The measurement doesn’t work with young companies: As plenty of hype swirls around IPOs, beta is one number that will never be part of the conversation. Because it’s calculated on historical price movements, you can’t effectively use beta to evaluate companies that have plans to go public or young companies that have recently been listed on Wall Street.