What is the beta of a stock? Meaning & Formula

Beta is associated with market risk, also known as volatility. Market volatility worries many (if not most) investors because it embodies uncertainty. Few people can tolerate uncertainty when it comes to their money, especially their retirement nest egg.

But in addition to analyzing an asset’s volatility profile, beta can also be used to make investment decisions in various strategic ways.

Your benchmark – whatever you use – will by definition have a beta of 1.0. This is a fundamental part of the Capital Asset Pricing Model (CAPM).

How to interpret the beta version:

A beta of 1 means an asset is perfectly correlated to the benchmark. In other words, a stock with a beta of 1 or close to it is expected to move roughly in sync with the benchmark. So if the S&P 500 (our benchmark) rises 5%, the CAPM would predict the stock to rise 5%.

Beta greater than 1 means the asset exists more more sensitive than the benchmark. In this scenario, the stock would move in the same direction as the benchmark – up or down – but its moves could be more exaggerated. So let’s say an asset has a beta of 1.5. If the S&P 500 falls 5%, the stock would fall 7.5%, according to CAPM.

Beta less than 1 means the asset exists fewer more sensitive than the benchmark. In other words, the stock would move with the benchmark, but not to the same extent. Imagine an asset with a beta of 0.25. If the S&P 500 rises 5%, the CAPM assumes the stock would rise 1.25%.

Zero and negative beta assets – do they exist?

Yes, they do, but usually not with traditional assets.

Zero beta assets. It is highly unlikely that a stock – or a fund that only holds a basket of stocks – will have no correlation with the market (i.e. a zero beta), although some may have low beta values.

Perhaps the best example of a zero beta asset is cash. Whether the S&P 500 rises or falls, the value of your dollar will not change. Next, in addition to cash, could be cash equivalents such as certificates of deposit (CDs), money market funds, and other fixed-income assets.

But remember: The S&P 500 – an index of large US stocks – isn’t really the right benchmark for these fixed income securities, so assigning a beta relative to the stock index isn’t particularly relevant.

Assets with negative beta. An asset with a negative beta is expected to perform inversely to the benchmark (it has a negative correlation). So if the S&P 500 rises, the CAPM suggests the asset will fall.

An extreme example of negative beta would be an inverse S&P 500 exchange-traded fund that targets a beta of -1 (or close to it) relative to the S&P 500 index (see Figure 1).

2: Projected returns relative to the market. Using beta to predict performance can be more difficult, but if you can factor in the other components of the CAPM – particularly the risk-free rate (typically represented by the yield on the 10-year U.S. Treasury note) and the average yield of B. a broad market index – then you have the basic numbers to calculate an asset’s estimated return.

For example, if an asset has a beta of 2 and your CAPM calculation predicts an S&P 500 return of 10%, the model may predict an asset return of 20%. Of course, this is not a foolproof forecast, especially in the short term. For example, a company may release a negative earnings report on a day when the broader market is rallying. As a stock’s return profile changes over long periods of time relative to the benchmark, its beta will also change.

3: Making the most of bull and bear markets. Another beta strategy would be to add to high beta assets – from individual stocks to sector ETFs – when the market is in an uptrend and low beta assets when the market is in a downtrend. The goal is to hold assets that are capable of outperforming the market’s upward move but underperforming its losses during a downturn.

4: Diversification and reorientation. You may be interested in building a more diversified portfolio – one that includes higher and lower risk stocks or funds, but in a way that spreads the risk. In this case, you can use beta values ​​to better manage or balance your stock or fund allocations. High beta assets may offer greater growth potential (but also more risk), while low beta assets may offer more stability (but lower growth potential).

Beta values ​​change, so be careful!

Beta is not a static value. Markets always fluctuate, as do individual stocks – meaning their covariance can also change over time. Small changes are inevitable, but big beta changes also happen. They often accompany significant changes in a company or changes in the industry, sector or market conditions.

If you use Beta to manage your portfolio, keep an eye on Beta changes. Note that they tend to be more significant over longer periods of time, such as years, than short-term fluctuations. However, significant short-term changes in beta can still occur in response to market shocks or conditions affecting specific companies, industries and sectors.

The end result

Beta can help you assess the volatility of a stock or fund relative to the market. This metric can also be used to build and manage your portfolio. But beta is not a fixed number, and as conditions change, so does beta. In other words, beta is an important metric, but it’s best to consider it alongside other important metrics.

For example, professional fund managers say that relative to the market, return is more important than risk. Alpha measures the fund’s “excess return” above what the market, beta and risk-free rate would suggest. For a deeper insight into risk and return, consider the Sharpe ratio (and its cousin, the Sortino ratio).

Finally, look at how your portfolio performs during major market sell-offs. Are you satisfied with the development of your portfolio? If not, it doesn’t matter what the circumstances tell you; It might be time to scale back the risk.