What is Beta in Finance?
The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is a performance index which measures the volatility and analyzes the risk of a stock. The indicator correlates the stock with a bigger index or a market . A company with a higher beta has greater risk and also greater expected returns.
The beta coefficient can be interpreted as follows:
- β =1 exactly as volatile as the market
- β >1 more volatile than the market
- β <1>0 less volatile than the market
- β =0 uncorrelated to the market
- β <0 negatively correlated to the market
Finding Stock Market Industry Beta is a measure of a stock’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
Stock Market Industry Beta is the measure of how a stock is trading price moves compared to the market as a whole. Knowing this figure one can understand how volatile a stock is. A beta of 1 means a stockís price fluctuates exactly as much as the market. A beta less than 1 means a stock is less volatile than the market and a beta greater than 1 means that stock is more volatile than the market.
Betas can be determined for entire industries also. The ìndustry beta would compare the volatility of the industry relative to the whole market. For example, technology stocks tend to be more volatile than the industry so the beta would be more than 1, generally.
To calculate industry beta you need some historical data of the price of the industry stock and historical price data of the entire market. For example if you were going to calculate beta over the last year for compare technology stocks versus the S&P 500, you would first gather the historical data you need. Next, determine the movements of the two prices after each trading day. This will give a percentage change versus the previous day. Once we have 365 of these we can average the group to determine the average move each made over the last year. We can call the average industry movement Ri and the average market movement Rm. Finally, divide the technology industryís average movement by the S&Pís average movement and we will have an outcome that is less than 1 (less volatile), 1 (equally volatile), or greater than 1 (more volatile). Written out this function looks like this:
Β = Ri / Rm or B = Covariance(Ri , Rm)/ Variance(Rm)
Beta can be useful in stock research when judging how risky a stock is versus a stable investment with a guaranteed rate of return. It must be noted that the longer period of time the beta is acquired the more accurate that beta will be. Also, betas are more valuable when used with stocks that have a long record of high volume trading. Smaller stocks that donít trade a lot can fluctuate wildly on a busy day and throw the beta out of whack for the period being measured.
Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market. An example of the first is a treasury bill: the price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price of gold does go up and down a lot, but not in the same direction or at the same time as the market.
A beta greater than 1 generally means that the asset both is volatile and tends to move up and down with the market. An example is a stock in a big technology company. Negative betas are possible for investments that tend to go down when the market goes up, and vice versa. There are few fundamental investments with consistent and significant negative betas, but some derivatives like put options can have large negative betas.
Beta is important because it measures the risk of an investment that cannot be reduced by diversification. It does not measure the risk of an investment held on a stand-alone basis, but the amount of risk the investment adds to an already-diversified portfolio. In the capital asset pricing model (CAPM), beta risk is the only kind of risk for which investors should receive an expected return higher than the risk-free rate of interest.
The definition above covers only theoretical beta. The term is used in many related ways in finance. For example, the betas commonly quoted in mutual fund analyses generally measure the risk of the fund arising from exposure to a benchmark for the fund, rather than from exposure to the entire market portfolio. Thus they measure the amount of risk the fund adds to a diversified portfolio of funds of the same type, rather than to a portfolio diversified among all fund types.
Beta decay refers to the tendency for a company with a high beta coefficient (β > 1) to have its beta coefficient decline to the market beta. It is an example of regression toward the mean.
In the U.S., published betas typically use a stock market index such as the S&P 500 as a benchmark. The S&P 500 is a popular index of U.S. large-cap stocks. Other choices may be an international index such as the MSCI EAFE. The benchmark is often chosen to be similar to the assets chosen by the investor. For example, for a person who owns S&P 500 index funds and gold bars, the index would combine the S&P 500 and the price of gold. In practice a standard index is used.
The choice of the index need not reflect the portfolio under question; e.g., beta for gold bars compared to the S&P 500 may be low or negative carrying the information that gold does not track stocks and may provide a mechanism for reducing risk. The restriction to stocks as a benchmark is somewhat arbitrary. A model portfolio may be stocks plus bonds. Sometimes the market is defined as “all investable assets” (see Roll’s critique); unfortunately, this includes lots of things for which returns may be hard to measure.
By definition, the market itself has a beta of 1, and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes, the S&P 500 Index is sometimes used as a proxy for the market as a whole). A stock whose returns vary more than the market’s returns over time can have a beta whose absolute value is greater than 1.0 (whether it is, in fact, greater than 1.0 will depend on the correlation of the stock’s returns and the market’s returns). A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.0.
A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market; when the market’s return falls or rises by 3%, the stock’s return will fall or rise (respectively) by 6% on average. (However, because beta also depends on the correlation of returns, there can be considerable variance about that average; the higher the correlation, the less variance; the lower the correlation, the higher the variance.) Beta can also be negative, meaning the stock’s returns tend to move in the opposite direction of the market’s returns. A stock with a beta of −3 would see its return decline 9% (on average) when the market’s return goes up 3%, and would see its return climb 9% (on average) if the market’s return falls by 3%.
Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have challenged this idea, claiming that the data show little relation between beta and potential reward, or even that lower-beta stocks are both less risky and more profitable (contradicting CAPM).In the same way a stock’s beta shows its relation to market shifts, it is also an indicator for required returns on investment (ROI). Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% − 2%)) in accordance with the financial CAPM model.
Some Interesting Beta Cases.
- Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.
- Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does not mean that it is risk-free. A beta can be zero simply because the correlation between that item’s returns and the market’s returns is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk-free endeavor.
- On the other hand, if a stock has a moderately low but positive correlation with the market, but a high volatility, then its beta may still be high.
- A negative beta simply means that the stock is inversely correlated with the market.
- A negative beta might occur even when both the benchmark index and the stock under consideration have positive returns. It is possible that lower positive returns of the index coincide with higher positive returns of the stock, or vice versa. The slope of the regression line in such a case will be negative.
- Using beta as a measure of relative risk has its own limitations. Most analyses consider only the magnitude of beta. Beta is a statistical variable and should be considered with its statistical significance (R square value of the regression line). Closer to 1 R square value implies higher correlation and a stronger relationship between returns of the asset and benchmark index.
- If beta is a result of regression of one stock against the market where it is quoted, betas from different countries are not comparable.
- Utility stocks commonly show up as examples of low beta. These have some similarity to bonds, in that they tend to pay consistent dividends, and their prospects are not strongly dependent on economic cycles. They are still stocks, so the market price will be affected by overall stock market trends, even if this does not make sense.
- Staple stocks are thought to be less affected by cycles and usually have lower beta. Procter & Gamble, which makes soap, is a classic example. Other similar ones are Philip Morris (tobacco) and Johnson & Johnson (Health & Consumer Goods).
- ‘Tech’ stocks are commonly equated with higher beta. This is based on experience of the dot-com bubble around year 2000. Although tech did very well in the late 1990s, it also fell sharply in the early 2000s, much worse than the decline of the overall market. More recently, this is not a good example.
- During the 2008 market fall, finance stocks did very poorly, much worse than the overall market. Then in the following years they gained the most, although not to make up for their losses.
- Foreign stocks may provide some diversification. World benchmarks such as S&P Global 100 have slightly lower betas than comparable US-only benchmarks such as S&P 100. However, this effect is not as good as it used to be; the various markets are now fairly correlated, especially the US and Western Europe.