Beta measures how volatile a stock is in relation to the broader stock market over time. A stock with a high beta indicates it’s more volatile than the overall market and can react with dramatic share-price changes amid market swings. So if you don’t have the stomach for vast price changes, you may want to avoid investing in high-beta stocks.
But beta is just one factor to consider when examining investments. This article will help you understand what it means and how you can use it to build a better portfolio that matches your risk tolerance. A financial advisor can also help you take advantage of beta to make better investment decisions.
Investors often calculate beta by comparing a stock’s price changes to the movements of a benchmark index, such as the S&P 500, throughout a 12-month period. We’ll discuss calculating beta yourself in a bit. But first let’s understand why it matters, since you can use plenty of free online tools and calculators to compute it yourself.
Beta is represented as a number. Based on beta analysis, the overall stock market has a beta of 1. And the beta of individual stocks determines how far they deviate from the broader market.
A stock with a beta equal to 1 assumes its price moves hand-in-hand with the market. Adding it to your portfolio may not add much risk.
A stock with a beta greater than 1 may indicate that it’s more volatile than the market. However, this could also mean it has the potential for stronger returns. Say your benchmark, or the market to which you’re comparing a stock, is the S&P 500. If the stock you’re analyzing has a beta of 2, that means the stock is twice as volatile as the market. If the S&P 500 goes up by 10% next year, you can expect the stock price to go up by 20%. However, it could plummet by just as much if the S&P 500 goes down by 10%.
If the stock has a beta less than 1, you can conclude that it’s less volatile than the overall market. This means that adding it to your portfolio may mitigate risk and may help in diversifying your investments.
Betas can also dip below 1 into negative territory. This indicates that the stock may respond in the opposite direction of the overall market. Using the previous example, you could expect the stock’s price to go up if the S&P 500 goes down and vice versa.
A stock can even have a beta of zero. This suggests that it acts independently of the overall stock market.Advantages and Disadvantages of Beta
Understanding beta may help you make some smart decisions around how you build your investment portfolio. If you have a low risk tolerance, for example, you may want to focus more heavily on stocks with betas greater than zero, but less than or equal to 1.
For example, you may want to avoid a tech company stock that tends to rise and fall below the market frequently. In essence, it would have a high beta and mean more risk.
But just like anything in the world of investing, it’s never that black-and-white. Keep in mind that beta relies on past information. And past good performance is never a guarantee of continued or greater performance in the future.
As a result, beta doesn’t help you dig into the fundamentals of the company that sells the stock. Consider a firm that has long been considered a safe company with a consistently low beta. The firm then enters a new sector and takes on major debt in its next few years. The company’s low beta level doesn’t factor in this new risk because of the beta calculation’s inherent reliance on past information.
However, beta may be a strong factor in quantifying risk if you’re the kind of investor who buys and sells stocks on a regular basis.
Nonetheless, beta can be one of many useful tools to have when evaluating your investments. So it’s important to at least calculate the beta of a stock you may be interested in purchasing.Before You Calculate Beta
Remember, beta measures how volatile a stock’s price may be in relation to a market benchmark. To get the most out of a good beta calculation, that benchmark must be as related to the stock as possible.
So if you’re examining the stock of a a large U.S. company, a good choice would be the S&P 500. This market index covers the 500 U.S. companies with the largest market capitalization. But if you’re looking at the stock of a company that’s more active overseas, you may want to use an international market index instead.
Again, keep in mind that beta relies on past performance. Decide on a particular time frame to examine. If you’re investing for the long term, you may want to factor in a time frame of about five to 10 years. If you’re a trader who buys and sells on a regular basis, consider using a few days or weeks.Steps to Calculate Beta
Now that you have that set, let’s begin crunching some numbers. To begin, gather the following:
Open the spreadsheet. In the first column, insert the dates for the range you selected. In the second column, enter the closing prices for the stock you’re considering. And in the third column, insert the closing prices for the index you’re using.
The next step is to compute percent daily price changes for the stock and the index. For each entry, subtract that day’s cost price from that of the previous day. Divide the result by the price of the previous day. Multiply by 100. The result is the percentage. That would update your spreadsheet.
Now, use a covariance formula to compare how the stock’s and index’s prices move in relation to each other. Divide this covariance result by the variance of only the index. This allows you to see how the stock and index prices moved in relation to one another, relative to how the index price moved on its own. Therefore, you get beta.
Beta = (Stock’s % daily change and Index’s % daily change) / (Index’s % daily change.)The Takeaway
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. However, beta has its limitations. It doesn’t account for how companies may undergo major changes in the future, for example. It also relies solely on past metrics. Still, it serves as one of many useful factors you can weigh when making investment decisions.Tips on Making Better Investment Decisions
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