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If you are investing based on a stock's fundamentals, beta has plenty of shortcomings. Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a portfolio. For example, utility stocks often have low betas because they tend to move more slowly than market averages. However, since beta is calculated using historical data points, it becomes less meaningful for investors looking to predict a stock's future movements. Another troubling factor is that past price movement is a poor predictor of the future. ﻿Beta coefficient(β)=Covariance(Re,Rm)Variance(Rm)where:Re=the return on an individual stockRm=the return on the overall marketCovariance=how changes in a stock’s returns arerelated to changes in the market’s returnsVariance=how far the market’s data points spreadout from their average value\begin{aligned} &\text{Beta coefficient}(\beta) = \frac{\text{Covariance}(R_e, R_m)}{\text{Variance}(R_m)} \\ &\textbf{where:}\\ &R_e=\text{the return on an individual stock}\\ &R_m=\text{the return on the overall market}\\ &\text{Covariance}=\text{how changes in a stock's returns are} \\ &\text{related to changes in the market's returns}\\ &\text{Variance}=\text{how far the market's data points spread} \\ &\text{out from their average value} \\ \end{aligned}​Beta coefficient(β)=Variance(Rm​)Covariance(Re​,Rm​)​where:Re​=the return on an individual stockRm​=the return on the overall marketCovariance=how changes in a stock’s returns arerelated to changes in the market’s returnsVariance=how far the market’s data points spreadout from their average value​﻿.
volatility of returns for a stock taking into account the impact of the company’s leverage from its capital structure Berkshire Hathaway. So, adding a down-trending stock with a low beta decreases risk in a portfolio only if the investor defines risk strictly in terms of volatility (rather than as the potential for losses). The offers that appear in this table are from partnerships from which Investopedia receives compensation. There is an interesting quote from Warren Buffett regarding the academic community and its attitude towards value investing: "Well, it may be all right in practice, but it will never work in theory."﻿﻿. Beta is also less useful for long-term investments since a stock's volatility can change significantly from year to year, depending upon the company's growth stage and other factors. The Capital Asset Pricing Model is a model that describes the relationship between risk and expected return. But broadly speaking, the notion of beta is fairly straightforward. Accessed Sept. 24, 2020. Investopedia uses cookies to provide you with a great user experience. A risk-adjusted return accounts for the riskiness of an investment compared to the risk-free rate of return.

Numerically, it represents the tendency for a security's returns to respond to swings in the market. Beta is a measure of the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole. For example, a gold exchange-traded fund (ETF), such as the SPDR Gold Shares (GLD), is tied to the performance of gold bullion.﻿﻿ Consequently, a gold ETF would have a low beta and R-squared relationship with the S&P 500. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. The offers that appear in this table are from partnerships from which Investopedia receives compensation. If a stock moves less than the market, the stock's beta is less than 1.0. While the concept of risk is hard to factor in stock analysis and valuation, one of the most popular indicators is a statistical measure called beta. Benjamin Graham, the "father of value investing," and his modern advocates tried to spot well-run companies with a "margin of safety"—that is, an ability to withstand unpleasant surprises. Beta is a measure of a stock's volatility in relation to the overall market. For example, the surprise announcement that the company Lumber Liquidators (LL) had been selling hardwood flooring with dangerous levels of formaldehyde in 2015 is an example of unsystematic risk.﻿﻿ It was risk that was specific to that company. CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital. So if a stock trades at $100 a share and then the next day it trades at$95 and then the next day it trades at $105, it’s swinging by 5% in a short time period. A stock with a beta of 1 has average volatility. A multi-factor model uses many factors in its computations to explain market phenomena and/or equilibrium asset prices. Beta is a measure of a stock's volatility in relation to the overall market. Here’s how to read stock betas: 1. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. It is used in the capital asset pricing model. The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period. These include white papers, government data, original reporting, and interviews with industry experts. Beta data about an individual stock can only provide an investor with an approximation of how much risk the stock will add to a (presumably) diversified portfolio. © 2020 TheStreet, Inc. All rights reserved. Technology stocks and small cap stocks tend to have higher betas than the market benchmark. Beta is useful in determining a security's short-term risk, and for analyzing volatility to arrive at equity costs when using the CAPM. Critics argue that beta does not give enough information about the fundamentals of a company and is of limited value when making stock selections. Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. We’ll get there. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities. That’s pretty volatile. Intuitively, it makes plenty of sense. The Treynor Index measures a portfolio's excess return per unit of risk. However, financial markets are prone to large surprises. It also provides insights about how volatile–or how risky–a stock is relative to the rest of the market. It's recommended that investors using beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns. The Capital Asset Pricing Model is a model that describes the relationship between risk and expected return. A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market. We also reference original research from other reputable publishers where appropriate. However, for investors with long-term horizons, it's less useful. Beta is a concept that measures the expected move in a stock relative to movements in the overall market. Positive correlation is a relationship between two variables in which both variables move in tandem. A stock's price variability is important to consider when assessing risk. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. In statistical terms, beta represents the slope of the line through a regression of data points. By using Investopedia, you accept our, Investopedia requires writers to use primary sources to support their work. For example, to hedge out the market-risk of a stock with a market beta of 2.0, an investor would short$2,000 in the stock market for every $1,000 invested in the stock. A range of$99 to \$101 is less volatile. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. A benchmark for correlation values is a point of reference that an investment fund uses to measure important correlation values such as beta or R-squared. "Key Information." For beta to be meaningful, the stock should be related to the benchmark that is used in the calculation.

These include white papers, government data, original reporting, and interviews with industry experts. Some come from the consistency of growth, in earnings, or dividends. The beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market. A beta of less than 1 isn’t so volatile. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.

Volatility is the variance in price from the mean. For starters, beta doesn't incorporate new information. Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. This matters to you, the investor. A beta that is greater than 1.0 indicates that the security's price is theoretically more volatile than the market. If a stock has a beta of 1.0, it indicates that its price activity is strongly correlated with the market. Beta doesn't help investors tell the difference. A value investor would argue that a company represents a lower-risk investment after it falls in value—investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Put options and inverse ETFs are designed to have negative betas. "Chairman's Letter-1984." Beta is calculated using regression analysis. A stock with a beta of 1.0 has systematic risk. Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is riskier than it was before it fell. Betas are merely rear-view mirrors, reflecting very little of what lies ahead. For most investors, that doesn't make much sense.