What Beta Means: How to Assess Risk of a Stock & Increase Profits

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 stock’s beta coefficient will represent how risky the stock has been over the past few years as compared to the overall market.

Table of Contents:

  1. What is beta in stocks?
  2. Beta calculation
  3. Using beta as a measure of risk
  4. Different types of beta
  5. Alpha in stocks
  6. Pros of considering beta when evaluating a stock’s risk
  7. Cons of considering beta when evaluating a stock’s risk
  8. Other ways to evaluate risk in stocks
  9. FAQs

Key Takeaways

  1. Beta is used to measure a stock or other investment’s risk
  2. Learn to calculate beta compared to the overall market
  3. There are pros and cons to using beta to evaluate future risk, since it’s a calculation based on past performance
  4. 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 stock’s beta, first you’ll 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 stock’s 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, you’ll use the variance of the stock market itself (or the S&P 500 index) as your benchmark index fund.

Do these calculations sound difficult?

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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 market’s 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 market’s returns are up, the stock price is down, but when the market’s 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.

  1. Historical betas: compare returns on a stock and returns on a market index during some past period. You can change whether you’re 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 stock’s beta, they’re referring to a historical beta over the past three years.
  2. 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, it’s due to extenuating circumstances, and given enough time the stock’s beta will move back towards 1.
  3. 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 investment’s 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 stock’s risk

  1. 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 stock’s past performance. The result is an accurate measurement of historical volatility compared to the overall market.
  2. Beta mathematically represents a stock’s moves for you, so you don’t have to rely on guesswork or hearsay. There is no bias in the calculation. You don’t have to trust a company’s press release or other third party research.

Cons of considering beta when evaluating a stock’s risk

While it’s important to look at a stock’s beta calculation, it won’t tell the full story when it comes to market risk. Consider the following:

  1. Don’t get stuck in the past. Beta is a backward-looking, singular measure that doesn’t 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 won’t take any of that into account.
  2. Beta doesn’t include qualitative factors that can play a significant role in a company’s 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 won’t be reflected in beta.
  3. Because it’s based on historical price movements, you can’t use beta to evaluate young companies. Companies that plan to go public, or that have recently had IPOs, can’t be effectively evaluated using beta.

Other ways to evaluate risk in stocks

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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 stock’s 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, it’s a stable, low risk stock. High bets means an asset’s 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.

The above content provided and paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.