One of the key factors to evaluate when considering investing in a stock is a risk. But how does one determine the level of risk and asset present? It all goes back to fundamental analysis and one of its principal measures — the Stock Beta.
“What is beta for stocks?” — you must be asking. Well, stock beta indicates how much a stock price moves in relation to an index, such as the S&P 500 or FTSE 100. On a very basic level, it tells us how volatile an asset is. An index always has a beta score of 1. A stock price that moves twice as much as the index is a 2, while a stock that only moves half as much as the index has a beta of 0.5.
The logic is straightforward, but what do the resulting numbers actually mean? The scores correspond directly to the risk level. Investors that have a low-risk tolerance and prefer slow but steadily growing companies should look for low beta stocks, meaning those with a beta just under or close to 1. A short-term investor or a trader who knows how to either sit out or reap the benefits of volatility, will get the most profit out stocks with beta values of 2, 3, or even higher.
Stock beta can also affect the size of a position. Considering that a low beta stock moves less than a high beta stock, you could invest more into a lower beta stock and less — into a higher beta stock. As a result, a 5% uptick could produce the same effect on the portfolio as a 10% growth when there is twice as much money in the 5% stock.
The beta of a stock formula
To calculate the beta of the stock you may want to either use an online calculator or a spreadsheet by putting in the following formula:
Beta = Covariance (Rs, RI) / Variance (RI)
Rs is the return of the stock
RI is the return of the index
Covariance is how the stock’s returns vary from the market’s returns
Variance is the dispersion of market returns
If your eyes glossed over from looking at this formula, we don’t blame you. It’s highly technical stuff and not everyone is equipped or willing to get in the weeds of it. Luckily, stock beta data is calculated and listed for you on most financial websites, so you can skip the math and go straight into the fundamental analysis.
Types of beta values
We’ve already briefly touched on what different beta values mean, and while this should be enough for a very superficial analysis, perhaps you want to go a bit deeper. Let’s take a look at the three most common groupings of beta values and what they could spell out for your investing journey.
A high beta value indicates that a stock moves more than the index and it is more volatile than the index or index funds. A stock with a beta of 3 will move roughly three times as much as an index, making this type of stock highly lucrative to traders, looking to profit from large price swings in a short period of time.
Low beta stocks usually have a beta below 1 and above zero. These stocks move slower than an index over the same time period. Less volatility typically brings lower returns, which is an excellent option for conservative long-term investors, but it’s not going to be much fun for those looking for price action and bigger returns on a smaller time frame.
You saw that right. Betas can have negative values. That’s what happens when the stock price moves in the opposite direction of the index. A beta of -1 means that the stock price moves in the opposite direction at the same rate.
At first glance it may seem like a negative beta stock is not worth your time. After all, aren’t we all after growth and not decline? True. But negative beta stocks may provide diversification to a portfolio. You see, if the index was to fall, the negative beta stock would most likely rise. Unexpected turns like that can and do happen for a well-balanced portfolio, that’s why it’s advisable to periodically check in on your stocks and shares ISA performance.
Pros and Cons of Beta
Beta can act as a proxy for assessing risk. It provides a clear benchmark that is easy to interpret and work with. And while beta calculations may vary based on the timeframe or the market index selected as a baseline, the concept itself is fairly straightforward and reliable.
However, if you mainly rely on fundamentals when considering stocks to invest in, the beta has plenty of shortcomings. For one, beta is calculated on pricing history, so naturally, it doesn’t incorporate new information. For example, if a low beta company was to suddenly branch out into a different industry or a new market — a venture that often entails occurring debt — the company’s stock could now hardly be considered low-risk. That’s the kind of information beta doesn’t have for you. Neither does it have much to offer in terms of brand new stocks that don’t have a long price history.
Furthermore, as the common risk warning goes: “past performance is not a reliable indicator of future results”. You can’t move forward by looking into the rear-view mirror instead of your windshield. Similarly, betas only reflect the past and can’t help you predict what lies ahead.
- A beta of the stocks is a value that’s neither good nor bad. It’s merely an indicator of volatility and associated risk that investors can use to determine if a stock is right for them.
- A balanced portfolio ideally includes both low and high beta stocks, as well as negative beta stocks for diversification.
- Under no circumstances should beta be taken as the only measure of risk. A stock’s beta is an indicator based solely on past performance and contains no new information, so further fundamental analysis must be performed.