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What is beta?
What is beta?
The simple definition is that beta is a statistical indicator of risk. It measures a stock’s volatility against the market as a whole, typically represented by a benchmark such as the S&P 500. The “market,” as an entity, has a beta of 1.0, and beta for individual securities represents how much a particular stock deviates from movements in the market as a whole. A stock with less movement than the market benchmark has a lower beta, while one that swings more has a higher beta. Theoretically, then, a stock with a beta below 1.0 is less risky, but will deliver lower returns, while one with a beta above 1.0 will generate higher returns, but also carry more risk. A security with a beta of 1.5 is 50% more volatile than the market, while one with a beta of 0.5 is 50% less volatile. When applied to returns, a beta of 2 would suggest a doubling of the benchmark. In other words, if the market gained 10%, the security would gain 20%. If the market lost 5%, the security would lose 10%. On the other hand, a security with a beta of 0.5 would halve the benchmark; if the market gained 10%, the security would gain 5%. In the range of beta, this is more or less what you might expect: Negative beta - theoretically possible, but not really, because it suggests an inverse relationship to the benchmark. Some argue that gold should have a beta of less than zero because it usually rises in value in a bear market. However, this isn’t always true; when the S&P declined nearly 30% between 1980 and 1982, gold dropped nearly 50%. Beta = 0 - Cash has a beta of 0, because in the absence of inflation, the value of cash stays the same regardless of moves in the market. Beta <1 - These are usually blue chips, such as Johnson & Johnson, Coca Cola, and GE. Beta = 1 - This stock mirrors the benchmark index with little to no variance. Beta >1 - These stocks are more volatile than the benchmark. Many securities on the Nasdaq have betas above 1, although few well-known companies ever have betas above 4. It is theoretically impossible to have a beta of 100, because it implies that the stock would zero out with
decline in the market. If you’re into math, beta uses regression analysis to quantify the tendency of a stock to respond to movements in the market. It represents the covariance of the security’s return with the benchmark (market) return divided by the variance of the benchmark’s return over a period of time.
In a bear market, a security with a high beta will likely do worse than the market, while it will outperform the market in a bull market—again, in theory. The problem with beta is that it doesn’t differentiate between upside and downside movements in price. If you’re the type of investor who sees risk in downside movement and opportunity in an upside one, beta isn’t going to help you much as a proxy for risk. Value investors also view beta with suspicion. A value investor argues a security that has experienced a sharp drop in price is
risky that it was at its higher price, even though its beta will rise as a result of the decline. After all, beta provides no useful information about the price of a security and its future cash flow. Even if you’re not a value investor, beta has plenty of disadvantages, not the least is that it is strictly a backward-looking measure that can’t account for new information. Imagine you’re looking at Telecom XYZ, a reliable dividend-paying stock with a beta of 0.7. If you’re looking for a defensive stock to combat volatility, this security might seem like a good bet based on its low beta. However, XYZ recently took on a significant amount of debt acquiring a potentially risky company. Beta has no way to account for that development or predict what the heavy debt load will do to the company’s performance going forward. Ultimately, beta is probably a more useful tool for short-term trades where beta and price volatility have a more significant impact. Longer-term investors should consider fundamental, big-picture risk in identifying opportunities.