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IN THE FIELD of investing, the term the 'beta' of a stock or share is an indicator of the movement of that stock's share price in relationship to the movement of share prices in the market as a whole. It is a comparative measure of an individual stock's past price volatility.
If a particular stock has a beta of 1 this means that the movement of its price has exactly matched the general movement of all prices in the market, i.e. there was an extremely close relationship with percentage value movements of the stock and that of the market.
But if a stock has a beta of 0 (zero), the movement of its price in the market has been seen to be the opposite to that of the general movement of prices in general in the market as a whole.
Therefore investors should give careful attention to the beta of a stock they are considering investing in.
ALTHOUGH the past is no sure guide to the future, market analysis attempts to spot trends -in the hope that, just maybe, the past IS a guide to the future!
Based on the assumption that a stock's beta (of past performance) is a good guide to its potential future performance, an investor who wants to 'run with the market' might choose a stock with the highest beta, i.e. the closer to 1 the better. They therefore expect, based on the past, that the stock's price will correspondingly rise when general market prices rise. On the other hand, the investor must expect the stock's price to fall when general market fall, and by a similar percentage.
But a stock with a beta of 0 (zero) closely counter-matches the market, and when markets have fallen, the beta 0 stock has risen by the same percentage, and when markets have risen, the beta 0 stock has fallen by a similar percentage.
AN INVESTOR who wants to 'beat the market', especially in a falling market economy, will look for stocks with low betas, but of course, they also run the risk of their stock losing value when the market is rising!
An investor who wants to take a more cautious/conservative approach, the middle-way, may choose a stock that falls partway between (a) 'responding with the market, one way or another!, and (b) being 'independent of the market'. In this case they might select a stock with beta of 0.5 which might better suit their expectations and attitude to risk.
MORE INFORMATION: CALCULATING THE BETA
The beta is computed using regression analysis. In our simple examples we have basically compared a beta of 1 with a beta of 0. However, if a stock's price responds with the market but shows co-related increases/falls that are actually 50% greater than that of the market, they will have a beta of 1.5
And if the stock still rises and falls with the market but its percentage increases and falls are double that of the market, it will have a beta of 2.
CONCLUSION
You can see, then, that the beta is a very interesting and important measure of a stock's past performance (in 'price' terms) in relationship with the Stock Market as a whole. But is the past a good guide to the future? It seems that the jury is still out on that one!
- For more information, see Related links below.
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Beta?
In my last post I discussed an investment metric known as alpha. Alpha is a gauge of risk-adjusted returns provided by a portfolio manager. Alpha isn’t the only measure of a stock or portfolio’s risk profile. Another one is called beta. Beta measures a stock’s volatility in comparison to the overall market. A beta value of 1 is assigned to the overall market. So a stock that has a beta of one would be considered to move in lockstep with the overall market. If the market were to go up by 10%, the stock should also move by the same amount in the same direction. A stock that moves less than the overall market would have a beta less than one. A beta greater than one indicates a stock that moves in the same direction as the overall market but in more extreme swings. Beta can be a good figure to use in rule-of-thumb investment decisions but it does have one serious drawback of which investors should be aware. Beta is calculated based on historical price movements relative to the market. Because of this method of calculation it doesn’t take into account any new information about the underlying fundamentals of the company. Due to this limitation, beta should never be used in a vacuum. Remember, statistics like alpha and beta can provide guideposts to help you evaluate an investment manager or the risk of a particular stock but they shouldn’t be relied upon to replace the hard work of fundamental analysis. It is the key things going on with a company’s balance sheet and income statement that are the true underpinnings of the stock’s valuation. Keep this in mind when evaluating stocks or portfolios and you’ll be in good shape. I’m not saying that statistics like alpha and beta should be ignored; they’re great tools. Just don’t let them be the only tools you use when making investment decisions.
