Beta Definition

The beta value of a stock is the proportion by which its returns vary in response to changes in the returns on other stocks.

A beta value will typically range between -1 and +1.

A stock that has a high beta means that the stock is more volatile than the overall market. This further means that it can easily be affected by share-price changes in the market.

How Does Beta Work?

On a beta analysis, the resulting beta will be a number between -1 and +1.

In finance, the beta coefficient measures how volatile an individual stock is compared to a market as a whole.

In statistical terms, this means that you have one point for every data point in your data set and its returns against those numbers from all other stocks – including their upside potentials or downside risks.

What Is the Use of Beta?

The use of the beta value is that it allows investors to compare various stocks’ risks.

Since the aim for the calculation of a stock’s beta is to figure out the movement of a stock compared to the rest of the market, it is important that the market used as comparison should be related to the stock. 

For example, investors will not compare an oil company’s beta with that of a technology company.

How Do You Use Beta?

The use of beta values can be used for both passive and active investments, though it tends to work well with passive investing – where you want your investment to track a benchmark like an index fund rather than trying to beat an index (like you would in active investing).

How Is Beta Calculated?

The formula to compute for a stock’s beta:

Calculating_Beta

What Are The Different Types of Beta Values?

Beta Value = 1

A beta value that is equal to one means that the stock is neither more volatile nor less volatile than the market. Thus, it is strongly correlated with that of the market.

Beta Value = Less than 1

A beta value that is equal to less than one means that the stock tends to trade very little in relation to general share-price movements. The stock in this case is theoretically less volatile than the market.

Beta Value = Greater than 1

A beta value that is greater than one means that the stock is more volatile than the overall market and can easily be affected by share-price changes in the market.

Negative Beta Value

A negative beta value means that the stock tends to actually rise in value when the market is falling. This phenomenon is known as being “countercyclical.”

Advantages and Disadvantages of Beta

Beta values allow investors to compare stocks more easily since they can be used interchangeably.

However, some say that there are problems with how it calculates for risk premiums because beta does not take into account any other factors that may affect volatility (such as earnings).

Moreover, there is no clear benchmark on what ‘volatile’ really means, which makes it a subjective concept.

Final Thoughts

Beta is a statistic used to determine how volatile or risky an investment may be compared to other investments. Over time, it tends to reflect changes in share prices due to changes in profitability and thus, earnings (which affects supply and demand).

A beta value is useful in that it allows investors to know how an individual stock will react with the rest of the market.

In spite of this, there are some limitations as to how accurate beta values can be since they do not fully take into account all variables that may affect volatility.

In addition, as numbers between -1 and +1 mean different things for each stock, investors cannot judge stocks based on just their betas alone, but have to consider other factors as well.

A counter-cyclical stock means that the price of its shares tend to rise during a period of economic downturn.
You should not compare individual stocks against indices because they are different in nature.
Beta values are difficult to use in active stock picking because they assume that the market always reflects efficient behavior in pricing in securities. However, there are times where the market is not able to correctly price a security and this renders beta calculations inaccurate - as it assumes that any movement of share prices will reflect changes on profitability and thus earnings (which may not be true).
Some companies have negative betas because they tend to rise when the rest of the market falls. This can occur due to factors such as diversification of revenue sources and stability of earnings that do not necessarily depend on economic conditions.
Beta measures the riskiness of a security by comparing its volatility to that of the market. It is used as part of a capital asset pricing model (alongside other variables such as risk free rate and systematic risk) to determine how much an investment will bring in based on its general share price movements compared to those of the market.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.