Therefore, if the market returns 10%, a stock with a beta of 1.2 will return 12%. A beta coefficient is used to measure the volatility of an individual stock in comparison with the wider stock market. A low Beta generally means that a stock is likely to fall under the low-risk, low-return category. On the flip side, a high Beta stock falls under the high-risk, high-reward category. Some stock traders are known to prefer high Beta stocks while certain stock investors are inclined to choose low Beta stocks.
Pros of considering beta when evaluating a stock’s risk
- Markets always fluctuate, as do individual stocks—which means their covariance can change over time as well.
- Note that they tend to be more significant over longer periods, such as years, compared to short-term fluctuations.
- The stock’s Beta is calculated as the division of covariance of the stock’s returns and the benchmark’s returns by the variance of the benchmark’s returns over a predefined period.
- While a higher alpha is always desirable, beta interpretation is not as straightforward.
- Investors and analysts often calculate unlevered beta to understand the intrinsic, operational risk of a business without the influence of its financing decisions.
A gold exchange-traded fund (ETF), such as the SPDR Gold Shares (GLD), is tied to the performance of gold bullion. Consequently, a gold ETF would have a low beta and R-squared relationship with the S&P 500. Beta (β) is the second letter of the Greek alphabet used in finance to denote the volatility or systematic risk of a security or portfolio compared to the market, usually the S&P 500 which has a beta of 1.0. Stocks with betas higher than 1.0 are interpreted as more volatile than the S&P 500.
Investors should also learn how other measures of performance and risk, like standard deviation, Sharpe ratio, Treynor ratio, Sortino ratio, and R-squared work to make well-rounded decisions. The alpha in mutual fund investments tells you whether the fund manager’s decisions have added value beyond what the market would have delivered on its own. That is, had you simply invested in an index fund that tracks the benchmark, would you have earned similar or better returns without paying for active management? In other words, the alpha ratio in mutual funds tells you how well or how poorly a fund is performing relative to its benchmark. A negative alpha means the fund has returned less than its benchmark.
However, to compare companies on a more equal footing, particularly across different industries or with varying levels of debt, you might want to calculate unlevered beta (βU), also known as asset beta. Unlevered beta strips out the effects of financial leverage and shows the company’s risk in relation to the market independent of its debt levels. Markets always fluctuate, as do individual stocks—which means their covariance can change over time as well. Small changes are inevitable, but major beta changes also happen. They often come with significant changes in a company or shifts in industry, sector, or market conditions. In finance, beta is a metric that represents the volatility of a security or fund relative to a benchmark.
What is Stock Beta?
Conversely, low-beta stocks pose less risk but also offer lower potential returns. Investors must ensure a specific stock is compared to the right benchmark and review the R-squared value to the benchmark. R-squared is a statistical measure that compares the security’s historical price movements to the benchmark index. A security with a high R-squared value indicates a relevant benchmark.
If not, it doesn’t matter what the ratios tell you; it might be time to dial back the risk. Although he was best known for developing the CAPM, Sharpe’s later work went a step further. He suspected that many portfolio managers were generating their returns by taking high levels of risk, but that their returns weren’t necessarily all that great after the amount of risk was factored in. Here are four ways you can use beta to inform your investment decisions.
Step #4: Calculate Beta for Every Security
Similarly, a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio, but it may increase gains. Investors who beta to evaluate a stock also evaluate it from other perspectives—such as fundamental or technical factors—before assuming it will add or remove risk from a portfolio. Ravi is the co-founder and director at Fincart, with over a decade of experience in wealth management Read more. He holds an MBA in Finance, a postgraduate diploma in financial planning and wealth management, a licentiate in Insurance, and has earned his domain-related certifications from NISM.
Q. Can beta be negative?
That is, if a portfolio consists of 80% asset A and 20% asset B, then the beta of the portfolio is 80% times the beta of asset A and 20% times the beta of asset B. Yes, Beta is useful for analyzing the risk of a diversified portfolio. It helps assess how the portfolio will react to market changes based on the Beta values of its individual components.
A positive alpha indicates outperformance, while a negative alpha suggests underperformance relative to the benchmark. Beta effectively describes the activity of a security’s returns as it responds to swings in the market. It is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets.
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By understanding your portfolio’s beta, you can make lh crypto broker overview informed decisions about risk management and asset allocation. Calculating the beta of a stock is essential for evaluating its risk relative to the market. Beta gauges how a stock’s returns correlate with the market’s movements, which is what its formula reflects. Beta measures the movement of a stock’s price in relation to a broader market index, such as the S&P 500 Index. This relationship is observed over a specific period and can be depicted by the slope of a line on a scatter plot. Your benchmark—whatever you use—will have, by definition, a beta of 1.0.
It’s used to evaluate the expected risks and returns of a portfolio, or to see whether a specific investment would be a good fit for a portfolio in terms of expected risks and returns. The investing information provided on this umarkets review 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. 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.
By fitting a regression line to these data points, it determines the slope, which represents beta. This slope indicates how much the stock’s returns are expected to change for a given change in the market’s returns, providing a nuanced view of the stock’s market sensitivity. A stock with a beta of 0.9 is less volatile than its benchmark, but what is the benchmark? Most investors assume the S&P 500 is the benchmark when looking at stock prices. However, would you use the S&P 500 to measure the volatility of corporate bonds?
This helps investors make informed decisions on which assets to include in their portfolios. Investors keen to bag big capital gains or day traders looking to make a quick buck from fluctuating share prices would be more interested in high-beta stocks. The share prices of these companies historically have a tendency to jump around quite a bit.
Financial Calendars
- But beta just tells us how reactive a stock tends to be when it comes to overall market forces.
- For this article and with most investing research, you will only be considering historical beta.
- However, beta alone is not a good indicator of the absolute risk of a fund.
- Holding a postgraduate degree in Business Economics, she has honed their skills through 4 years of experience in financial planning and portfolio management.
Investment returns and principal value will fluctuate such that an investment, when redeemed, may be worth more or less than the original cost. Alpha, meanwhile, measures the excess return of an investment compared with a benchmark index, after accounting for beta. In essence, alpha is the value that a portfolio manager or investment strategy adds above what would be expected given the investment’s level of market risk.
See our Investment Plans Terms and Conditions and Sponsored Content and Conflicts of Interest Disclosure. Options.Options trading entails significant risk and is not suitable for all investors. Options investors can rapidly lose the value of their investment in a short period of time and incur permanent loss dragonfly doji meaning by expiration date. Certain complex options strategies carry additional risk and costs.
Additionally, we’ll cover the concepts of levered versus unlevered beta and discuss the drawbacks of using beta. This knowledge is valuable, as beta is a key element in numerous financial models and indicates the volatility risk in stocks and portfolios. The value of Bonds fluctuate and any investments sold prior to maturity may result in gain or loss of principal.