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.
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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.
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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 invested in the stock.
A stock that swings more than the market over time has a beta above 1.0. Stocks that have a low beta, such as consumer staples, are often used to hedge a portfolio of higher-beta stocks. These low-beta stocks are relatively unaffected by the market’s gyrations or even benefit in times when the economy is poor. Investors can still try to minimize the level of exposure to systematic risk by looking at a stock’s beta, or its correlation of price movements to the broader market as a whole. Diversification cannot help an investor to smooth out systematic risk, given that it affects all or most industries.
I.E. some guy who goes out and spends a christmas bonus on gold/guns. This is what makes finding a non-financial/derivative negative beta stock so hard. Obviously if ur using the CAPM to arrive at cost of capital in a situation of the firm having negative beta, ur cost of capital will be lower than ur risk free rate. Think of comparing the beta of different stocks in the same way you might order food at a restaurant. Working with an adviser may come with potential downsides, such as payment of fees (which will reduce returns).
Another troubling factor is that past price movement is a poor predictor of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead. Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable.
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. Beta is a measure that reflects how strongly a stock’s price tends to move in relation to the broader market’s movements. It helps investors estimate how much a stock might amplify or dampen the market’s ups and downs when added to a portfolio. A beta value of 1.5 implies that the stock is 50% more volatile than the broader market.
Can betas be negative? (and other well used interview questions)
Analysts use beta when they want to determine a stock’s risk profile. A company behind the next big thing typically commands a high valuation. Investors buy the stock based on it living up to its potential, which requires lots of uncertain factors going its way. A slip-up could result in the share price tumbling dramatically. Likewise, a small hint of good news can lead to another big rally.