Using Beta to Guide Your Investment Decisions

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Using Beta to Guide Your Investment Decisions

Stocks are volatile by nature; their prices move up and down hour by hour. There is always the possibility that a stock will lose some of its value and that the investor will lose money. But this volatility also makes it possible for investors to make significant gains—if they make the right choices.

What is beta?

Investment analysts use the Greek letter beta (Β) to represent the measurement of a stock’s relative market risk. It measures the degree to which a stock price fluctuates in relation to the overall market—otherwise known as the stock’s volatility.

Where it starts

The baseline for this measurement is the overall market, which has a beta of 1. Any stock with a beta greater than 1 is more volatile than the overall market. Any stock with a beta less than 1 is less volatile than the market. Let’s look at a hypothetical situation to illustrate this point.

Some illustrations of beta

Say a hypothetical Internet company we will call Widget.com has a beta of 2.0. This means it is two times as volatile as the overall market. Let’s say we expect the market to provide a return on investment of 8 percent. We would expect Widget.com to return 16 percent. However, if the market declines and were to provide a return of -5 percent, investors in Widget.com could expect a loss of 10 percent on their investment.

Conversely, let’s say that Local Telecom has a beta of 0.5. This means that it is half as volatile as the overall market. In our hypothetical market, then, Local Telecom should have a return on investment of only 4 percent when the market rises 8 percent, but should only have a negative return of 2.5 percent if the market drops by 5 percent.

Let beta influence your decision

Of our two companies, it is clear that Local Telecom is a much less volatile investment than Widget.com. However, Local Telecom’s returns are also lower when the market has positive returns. This is the fundamental trade-off between risk and return. The beta equation helps investors identify the kinds of stocks that provide the degree of risk they are willing to accept, in order to achieve the gains they want.

Beta and your risk tolerance

Investors who are very risk-averse should put their money into investments with low betas. Utility stocks and Treasury bills are examples of investments with low betas. On the other hand, those investors who are willing to take on more risk in the hopes of greater returns may want to invest in stocks with higher betas.

Where to find betas

Major brokerage firms calculate the betas of securities they trade, and then publish their calculations regularly in what are called beta books. In these books, you can look up the estimated betas of publicly traded companies, along with some other useful statistics. Many brokers and online financial information services also publish the betas of stocks and mutual funds, which you can look up on their Websites.