Using Beta to Understand a Stock’s Risk
Instead, negative beta means your investment offers a hedge against serious market downturns. Beta (β) is the second letter of the Greek alphabet used to measure the volatility of a security or portfolio compared to the S&P 500, which has a beta of 1.0. A Beta of 1.0 shows that a stock has been as volatile as the broader market. Betas larger than 1.0 indicate greater volatility, and betas less than 1.0 indicate less volatility. Times Interest Earned Ratio (Interest Coverage Ratio): The Complete Guide to Measuring Debt Servicing Capability High-beta stocks are supposed to be riskier but provide higher return potential. Conversely, low-beta stocks pose less risk but also offer lower potential returns. Beta is a component of the capital asset pricing model (CAPM), which is widely used to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. Note that beta can also be calculated by running a linear regression on a stock’s returns compared to the market using the capital asset pricing model (CAPM). Levered beta includes both business risk and the risk that comes from taking on debt. We and our partners process data to provide: Other factors, such as our own proprietary website rules and whether a product is offered in your area or at your self-selected credit score range, can also impact how and where products appear on this site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. Beta allows for a good comparison between an individual stock and a market-tracking index fund, but it doesn’t offer a complete portrait of a stock’s risk. Instead, it’s a look at its level of volatility, and it’s important to note that volatility can be both good and bad. The downward price movement, of course, will keep people up at night. Remember, beta measures how volatile a stock’s price may be in relation to a market benchmark. What Is Beta in Finance and Stock Markets? Measure, Explained Beta is the volatility of a security or portfolio against its benchmark. Beta focuses on market risk and does not account for company-specific risks, such as management changes, product launches, or operational issues. For example, conservative investors may prefer low-Beta stocks, while those seeking higher returns may invest in higher-Beta assets. The Capital Asset Pricing Model (CAPM) is a foundational theory in modern finance that helps investors determine the expected return on an asset, based on its risk relative to the broader market. Different sectors of the economy may have various beta values. In portfolio management, beta is used to construct a portfolio that matches can beta be negative the investor’s risk tolerance. By combining securities with different betas, a portfolio’s overall risk can be managed. A stock with a high Beta is expected to show larger price fluctuations. Investors can predict how an asset will behave in different market conditions, allowing them to adjust their strategy accordingly. Some of these risks are at the forefront in the current markets. Do you want positive or negative beta? A stock with a very low beta could have smaller price swings, yet still be in a long-term downtrend. So, adding a down-trending stock with a low beta decreases the risk in a portfolio only if the investor defines risk strictly in terms of volatility and not potential losses. Investors must ensure that a specific stock is compared to the right benchmark and review the R-squared value relative to the benchmark. R-squared is a statistical measure that compares the security’s historical price movements to the benchmark index. An investor uses beta to gauge how much risk a stock adds to a portfolio. To get the most out of a good beta calculation, that benchmark must be as related to the stock as possible. However, in the world of investing, things are rarely black and white. Beta is based on historical data, and past performance doesn’t guarantee future outcomes. This means beta alone doesn’t give insight into a company’s fundamentals or its potential for future risks. Understanding beta can be a valuable tool when building your investment portfolio. For those with a low risk tolerance, focusing on stocks with betas between 0 and 1 may align better with your financial goals. These stocks tend to be less volatile than the broader market, which can offer more stability. It can be read as a straightforward indicator of its price volatility in comparison with the stock market at large and in comparison with its peers. A very conservative investor might avoid any stock with a beta of more than 1, as it could indicate an unacceptable degree of risk. Essentially, beta expresses the trade-off between minimizing risk and maximizing return. On the other hand, if the market declines by 6%, investors can expect a loss of 12%. InvestingPro offers detailed insights into companies’ Beta including sector benchmarks and competitor analysis. Once you’ve calculated the beta of a stock, it can then be used to tell you the relative correspondence of price movements in that stock, given the price movements in the broader market as a whole. It compares the volatility (risk) of a levered company to the risk of the market. Some of these risks are at the forefront in the current markets. Beta can be a useful metric to determine how a stock’s price may move in relation to the overall market by examining its past performance. It can also be a useful indicator of risk, especially for investors who make trades frequently. It doesn’t account for how companies may undergo major changes in the future, for example. Still, it serves as one of many useful factors you can weigh when making investment decisions. Beta is the hedge ratio of an investment with respect to the stock market. 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