Beta is used in the capital asset pricing model (CAPM), a widely used method for pricing risky securities and for generating estimates of the expected returns of assets, particularly stocks. The CAPM formula uses the total average market return and the beta value of the stock to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. In this way, beta can impact a stock’s expected rate of return and share valuation. Beta values can shift over time because they’re tied to market fluctuations. Investors use beta to align their portfolios with their risk tolerance levels, targeting high-beta stocks for potentially higher returns with more risk, or low-beta stocks for added stability. In finance, the beta (β or market beta or beta coefficient) is a statistic that measures the expected increase or decrease of an individual stock price in proportion to movements of the stock market as a whole.
Beta in Portfolio Diversification
Not surprisingly, there are exchange-traded funds that concentrate on low-beta choices. Low-beta choices include covered call funds, low-beta sector focus, and bond funds. Bond funds include the iShares 1-5 Year Investment Grade Corporate Bond ETF and Wisdom Tree Floating Rate Treasury Fund.
A beta less than 1.0 suggests the security will be less volatile than the market, while a beta greater than 1.0 indicates the security will be more volatile. Similarly, inflation risk and interest rate risks are in focus amid rising prices. In simple terms, systematic risk is the risk that you assume while investing in stock markets. 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. Adding stocks with a beta greater than 1 would add more volatility relative to the market (and the potential for higher returns).
Beta Risk vs. Beta
A beta of 1.0 means the stock over the allocated time frame moved similar to the rest of the market. The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn’t distinguish between upside and downside price movements.
- One major drawback of beta is that it’s a backward-looking metric.
- Beta is a component of the capital asset pricing model (CAPM), which is widely used to determine the rate of return that shareholders might reasonably expect based on perceived investment risk.
- Think of comparing the beta of different stocks in the same way you might order food at a restaurant.
- An interesting application of hypothesis testing in finance can be made using the Altman Z-score.
They are still stocks, so the market price will be affected by overall stock market trends, even if this does not make sense. The arbitrage pricing theory (APT) has multiple factors in its model and thus requires multiple betas. Most fixed income instruments and commodities tend to have low or zero betas; call options tend to have high betas; and put options and short positions and some inverse ETFs tend to have negative betas. Investment professionals use this expected return, in conjunction with other valuation methods, as a basis for investment decisions.
Beta and Active vs. Passive Investing
It gives investors a way to relate expected return to the level of risk they assume. 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. Racy stocks, such as tech upstarts with the potential to revolutionize how certain things are done, fall into this category.
The maker of can beta be negative household brands such as Pampers, Oral, Pantene, and Gillette, as of June 2024 has a five-year beta of 0.42. In other words, its share price fluctuates much less than the broader market. For every 1% move in the market, Proctor & Gamble’s shares moved 0.42% on average.
Musings on Markets
High beta stocks are riskier but can offer higher returns, while low beta stocks are less risky but may yield lower returns. Beta is a statistical measure that compares the volatility of a particular stock’s price movements to the overall market. In simple terms, it indicates how much the price of a specific security will move in relation to market movements. A beta of 1.0 indicates that the security’s price will move with the market.
A Beta of 1.0 shows that a stock has been as volatile as the broader market. Betas larger than 1.0 indicate greater volatility and betas less than 1.0 indicate less volatility. Beta can provide some risk information, but it is not an effective measure of risk. Beta only looks at a stock’s past performance relative to the S&P 500 and does not predict future moves. It also does not consider the fundamentals of a company or its earnings and growth potential. A classic example of a low beta stock would be a company like Proctor & Gamble.