The resulting beta coefficient will be greater than or lower than 1 since 1 equals the market return (i.e., the annual average return of the S&P 500). Since a single integer represents beta, it’s easily interpreted and factored into stock and portfolio analysis. You can easily recognize a beta of 1.35 as 35% more volatile than its benchmark. Beta allows for a good comparison between an individual stock and a market-tracking index fund, but it doesn’t offer a complete portrait of a stock’s risk.
It can show the relationship between a hedge fund’s returns and the market return. Beta can show how much risk the fund is taking in certain asset classes and can be used to measure against other benchmarks, such as fixed trade99 review income or even hedge fund indexes. This measure can help investors determine how much capital to allocate to a hedge fund or whether they would be better off keeping their exposure in the equity market or even cash.
For example, a gold ETF will show a low β and R-squared in relation to a benchmark equity index, as gold is negatively correlated with equities. Beta is used as a proxy for a stock’s riskiness or volatility relative to the broader market. A good beta will, therefore, rely on your risk tolerance and goals. If you wish to replicate the broader market in your portfolio, for instance via an index ETF, a beta of 1.0 would be ideal.
The value of any stock index, such as the Standard & Poor’s 500 Index, moves up and down constantly. At the end of the trading day, we conclude that “the markets” were up or down. An investor considering buying a particular stock may want to know whether that stock moves up and down just as sharply as stocks in general. It may be inclined to hold its value on a bad day or get stuck in a rut when most stocks are rising. One major drawback of beta is that it’s a backward-looking metric. It’s calculated based on past returns, which may not be consistent with future returns.
How to Interpret a Stock’s Beta
Conversely, if you feel that your portfolio is too risky — that you can’t stomach its big upward and downward swings — then there’s a good chance that your portfolio has a beta greater than 1. Adding stocks with betas of less than 1 would help decrease volatility relative to the market. The investing information provided on this page is for educational purposes only. NerdWallet, Inc. does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks, securities or other investments.
With this metric, you can use broader market research to assess the risk of buying, selling, or holding a stock. That is a safer approach than looking at the asset individually. We’ll see how to calculate beta using the broader stock market and benchmark indices. High-beta stocks (greater than one) have the potential for higher returns. However, they carry a higher risk as they are more volatile. The same volatility that gives higher returns can cause more losses on the other end.
Beta Coefficient
It also provides insights about how volatile—or how risky—a stock is relative to the rest of the market. Beta, often represented by the Greek letter β, is a way of measuring the volatility of the returns you get from an investment. Volatility is a measure of how much and how quickly the value of an asset rises and falls. In financial markets, risk and volatility are closely related concepts. But remember that beta is a backward-looking measure of one specific type of risk. Consider looking at a stock’s fundamentals along with its beta when deciding whether to add it to your portfolio.
- The beta is the number that tells the investor how that stock acts compared to all other stocks, or at least in comparison to the stocks that comprise a relevant index.
- They are not ideal for bullish seasons, as they drag your profits down.
- Beta effectively describes the activity of a security’s returns as it responds to swings in the market.
- In the short-term, beta can give frequent traders an indication of risk.
In investing, beta does not refer to fraternities, product testing, or old videocassettes. That is, it indicates how much the price of a stock tends to fluctuate up and down compared to other stocks. The beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective. Therefore, what a stock’s beta might predict about a stock’s future movement isn’t always true.
Is it better to have a high or low beta in stocks?
However, they offer little profit in the short term if the market doesn’t vary much or remains relatively stable. We touched sparingly on interpretation when avatrade answering the question (What is beta in stocks?) at the beginning of this article. You can look at the beta and decide if a stock is worth investing in.
Still, you need to be certain of the variables in the calculation before using it as a tool. Suppose you know a stock’s 0.9 beta was found by using the S&P 500’s average five-year return as a benchmark. In that case, you can decide whether its volatility profile matches your portfolio prerequisites. Stocks that are more volatile than the index will have a higher beta; stocks that are less volatile than the benchmark will have a lower beta. Beta is a crucial component in the Capital Asset Pricing Model (CAPM) and can be used to measure the risk of an investor’s portfolio versus the overall market. The most rudimentary way to use beta is to realize that high beta stocks could increase your portfolio risk while low beta stocks could reduce it.
While we’ve extensively answered the question, (What is beta in stocks?), the real value comes in portfolio construction. By identifying highly volatile stocks and comparing them with your risk tolerance, you can determine which assets to add to your portfolio. The best approach etoro review is to have a balance of high- and low-volatility assets. Besides predicting a stock’s volatility, the beta can also offer insights into a stock’s historical price movements. The question (What is beta in stocks?) is worth asking, as the parameter is simple but insightful.
As the overused yet important adage goes, “past performance is not a guarantee of future success”. Either way, Beta is known to be a useful component in online intraday trading strategies. The Beta value can also be an indicator of a stock’s ability to generate returns. If you’re looking for a simple explanation of Beta value, you’ve come to the right place!
CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital. Professional portfolio managers calculate alpha as the rate of return that exceeds the model’s prediction or comes short of it. They use a capital asset pricing model (CAPM) to project the potential returns of an investment portfolio. Beta is the hedge ratio of an investment with respect to the stock market. For example, to hedge out the market-risk of a stock with a market beta of 2.0, an investor would short $2,000 in the stock market for every $1,000 invested in the stock. Thus insured, movements of the overall stock market no longer influence the combined position on average.
This displays a list of stocks that have a beta higher than 2. Traders can add additional filters, such as country, exchange, and index. Alternatively, Longer-term investors who favor defensive stocks can use the screener to find candidates with a beta below 1. For individual investors, alpha helps reveal how a public or private stock or fund might perform in relation to its peers or to the market as a whole. Alpha and beta are two of the key measurements used to evaluate the performance of a stock, a fund, or an investment portfolio. It compares the stock to a benchmark index, like the S&P 500.
