![How Does Beta Work? [image: finesolconsult.com]](http://www.getmoneyenergy.com/wp-content/uploads/2010/03/beta_trends_o8.jpg "How Does Beta Work? [image: finesolconsult.com]")
If you’ve never paid attention to Beta (β) (or “B”) before, listen up. Even if you don’t consider yourself a technical analyst or a seasoned investor, or if you are just getting into stocks now, beta is fairly easy to understand and can help you with your stock picking decisions.
Beta is a mathematical measurement of the fluctuations in a given stock. BUT – it is not exactly a measure of mere “volatility.” I used to think a stock’s beta just referred to how volatile (and thus how potentially risky) a stock could be. But that’s not exactly quite right. Beta doesn’t measure pure volatility, although it is still an indicator of risk.
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Beta Measures Deviation From Market Fluctuations
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Rather than measuring raw volatility as such (how much a stock can move up or down within a given period of time), Beta measures how much the stock tends to deviate from the market average or index.
You might see beta numbers of -0.56, 0, 0.21, 1, 1.63 or even 2.
One (1) represents the market average. Thus, a beta that deviates away from one (1) is an indication of how much the stock deviates from the market on average. A beta of zero (0) represents a stock that has no correlation to the market, while a beta in the negative can refer to a stock inversely correlated to a significant degree with the market.
Betas higher than one (1) indicate stocks that move around more than the market itself does, and so designate potentially riskier stocks.
Betas lower than one (1) indicate stocks that move up and down less often and in lesser amounts than the market itself does, and represent more stable stocks.
If a stock has a beta of three (3), for example, it means that the stock generally follows (is correlated with) the market but will jump higher or lower by a factor of about three. Hence the names we have for some of our leveraged ETF plays on certain indexes. If you’re invested in a Gold Bull 2x ETF, that means the ETF has a beta of 2 and will reflect the underlying index by a factor of two, or double whatever the index does.
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So how do you use this knowledge? Simple. In general, you can still think of beta as indicating the amount of risk in a stock. Beta will show you the size and frequency of the possible swings in the stock. If you’re more of a trader, you might look for higher betas because they could give you more opportunity for taking profits.
If you’re a buy-and-hold investor, you want to look for lower betas (between zero and one) because you’re not looking for dramatic swings, just steady growth.
If you want to protect yourself from possible swings in the market, look for low betas. But if you want to take on more potential risk in the hopes of greater torque on the upside, look for some higher numbers. A note of caution: a beta of 1.6 can still be quite high. Compare the stocks you’re familiar with to get a better sense of the movements that their betas reflect. Look up their 5 and 10-year charts to see what it looks like.
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{ 4 comments… read them below or add one }
Learned about this in college (finance major) but forgot since. I can see the usefulness of beta in the way you’ve explained it here. An entire text book explained in 300 words–way to go!
I think too that with the elevator like rises in the markets in the 80s and 90s, the perceived need for beta kind of went away. Concept and popularity (Nifty 50) trumped tech analysis and even fundamentals. This is probably a good time to revisit with the markets looking directionless.
@Kevin – wow, thank you;) I’m hoping other investors who might be more knowledgeable than me can correct or refine my points where I’m wrong or vague. Good point about the increased need for beta analysis these days.
Excellent description of the technical aspects of stock. Makes me think even for a long-term investor or one looking income with dividends it would make sense to use this an a secondary filter to fine tune investment decisions.
I always wanted to know about the beta factor of my stocks. I often heard technical analysts talking about beta in news channels and financial talk shows. But to my astonishments no one ever expained a singly line about beta. I only had an idea that beta depicted the riskiness of a particular stock. But this was all guess work.
With your explanation (extremely simple) now I can say I know beta and better I know how to use beta in my investment decisions. Thanks a lot