What is beta in stocks?
Beta is a calculation meant to measure a stock’s volatility compared with the overall market’s volatility. If you think of risk as the possibility of stock price dipping in value, beta can help you identify risky stocks. The overall stock market has a beta of 1, and a stocks beta coefficient will represent how risky the stock has been over the past few years as compared to the overall market.
Table of Contents:
- What is beta in stocks?
- Beta calculation
- Using beta as a measure of risk
- Different types of beta
- Alpha in stocks
- Pros of considering beta when evaluating a stocks risk
- Cons of considering beta when evaluating a stocks risk
- Other ways to evaluate risk in stocks
- FAQs
Key Takeaways
- Beta is used to measure a stock or other investments risk
- Learn to calculate beta compared to the overall market
- There are pros and cons to using beta to evaluate future risk, since its a calculation based on past performance
- Dive deeper into different types of beta and alpha in stocks
Beta calculation
The basic calculation for a beta coefficient requires knowing two factors: variance and covariance.
Beta = covariance variance
The calculation seems simple, but understanding covariance and variance can be complicated.
To calculate an individual stocks beta, first youll calculate the covariance (a measure of how two securities move in relation to one another) of a stock with the overall market (usually represented by the S&P 500 Index).
A positive covariance means the compared stocks tend to move together when their prices go up or down, i.e. a stocks price may move with the overall market.
A negative covariance means the stocks move opposite of each other.
Variance measures the volatility of an individual stock’s price over time. In the case of calculating beta, youll use the variance of the stock market itself (or the S&P 500 index) as your benchmark index fund.
Do these calculations sound difficult?
Dont worry. Public.com offers The Morningstar Rating for premium users. The Morningstar Rating is a measure of a fund’s risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the historical best performers receiving 5 stars and the worst performers receiving a single star. This can help make it easy to decide which stocks might be right for you.
Using beta as a measure of risk
The level of beta represents the systematic risk of a stock. A stock that is more volatile than the market over time has a beta greater than 1.0 and is a high-beta stock. High-beta stocks may be riskier, but provide the potential for higher returns. If a stock moves less than the overall markets volatility, that stock is a low-beta stock with a measurement of less than 1.0. Low-beta stocks pose less risk, but bring the potential for lower returns.
A negative beta, or beta of less than 0, is possible but highly unlikely. A negative beta would indicate that a stock has inverse reactions to the market: when the markets returns are up, the stock price is down, but when the markets returns are down, the stock price is up.
Different types of beta
The three types of stock beta are historical beta, adjusted beta and fundamental beta. For this article and with most investing research, you will only be considering historical beta. But professional financial analysts may also consider the other types of beta, so you may want to know what they are.
- Historical betas: compare returns on a stock and returns on a market index during some past period. You can change whether youre looking at the past few days or weeks, or several years. There is no set time period. This way, you get the best information for your individual investment strategy. When most people talk about a stocks beta, theyre referring to a historical beta over the past three years.
- Adjusted betas: are calculated as an average between the historical beta and 1.0. Basically, the idea is that if a stock has a beta of far over or under 1, its due to extenuating circumstances, and given enough time the stocks beta will move back towards 1.
- Fundamental beta: is a beta calculation that attempts to take into account recent changes to the company that may affect the future. This can be difficult as there is no one set calculation for fundamental beta.
Alpha in stocks
Alpha is another measure of risk in addition to beta that measures returns after adjusting for overall market volatility and random fluctuation. An alpha calculation of zero suggests that a stock has earned a return equal to the risk. An alpha above zero means an investment outperformed. A negative alpha may mean the investments risk was not worth the return.
Alpha is a risk indicator for mutual funds, stocks, and bonds that is related to beta. It tells investors whether an asset has performed better or worse than the beta predicted.
Pros of considering beta when evaluating a stocks risk
- Beta uses a pretty large amount of data to reflect an accurate depiction of historical risk. Beta calculation usually uses at least 36 months of measurements to look at a stocks past performance. The result is an accurate measurement of historical volatility compared to the overall market.
- Beta mathematically represents a stocks moves for you, so you dont have to rely on guesswork or hearsay. There is no bias in the calculation. You dont have to trust a companys press release or other third party research.
Cons of considering beta when evaluating a stocks risk
While its important to look at a stocks beta calculation, it wont tell the full story when it comes to market risk. Consider the following:
- Dont get stuck in the past. Beta is a backward-looking, singular measure that doesnt incorporate any other information you may have about how the stock will perform in the future. Considering upcoming business prospects and potential market disruptions is crucial to choosing investments. Beta wont take any of that into account.
- Beta doesnt include qualitative factors that can play a significant role in a companys outlook. Did the company just get a fresh round of funding? Did it merge with another company? Factors like this will affect the future stock price but wont be reflected in beta.
- Because its based on historical price movements, you cant use beta to evaluate young companies. Companies that plan to go public, or that have recently had IPOs, cant be effectively evaluated using beta.
Other ways to evaluate risk in stocks
Public.com offers a suite of tools to help you decide which investments are right for you. You can stay on top of upcoming changes at companies you invest in by hearing directly from their executives at Town Halls. Plus, hear perspectives from research analysts and explore institutional-grade research from Morningstar. Public makes it easy to access the information you need to make better investment decisions at your fingertips.
When you discover the investment thats right for you, you wont have to wait long to invest. Public provides the Instant Transfer feature to make sure you can invest right away.
Frequently asked questions
What is a good beta in stocks?
There are no morals attached to beta calculations. Beta simply tells you whether the stock has historically been more or less volatile than the market. So a low beta carries less risk than a high beta. However, a high beta does not tell you how the stock is performing, other than that it has changed in price a lot. It may still carry a much higher stock price than it did several years ago. Whether you want to choose a high or low beta stock depends on your investment strategy.
Is a high beta in stocks good?
That completely depends on your investment strategy. A low beta will be a less risky, more stable stock. But if you want to take a bigger risk in order to potentially make bigger profits, a high beta stock may be right for you.
What does a stock beta of 1.5 mean?
A stock beta of 1.5 means that a stocks volatility is 1.5 times that of the overall stock market. The price is moving up or down at a higher rate than the S&P 500 has over the past few years.
What is the difference between a high-beta and a low-beta?
Low beta means a stock historically swings up and down less than the market, its a stable, low risk stock. High bets means an assets price has been historically more volatile than the market, bringing greater risk.
Does a higher beta mean more risk?
Yes, a higher beta coefficient means an investment is risky compared to the overall market causing larger up or down swings in price. However, risk and reward sometimes are correlated, so there may be an opportunity for an upswing that could be profitable.