What is Beta in Stocks
What is Beta – How Beta is Calculated – How Beta is Used
What is Beta?
In short:
Beta in stocks is a statistical standardized measurement of the volatility of a financial instrument, in our case a stock, against the market as a whole, normally “market as a whole” is the S&P 500. A quicker more simplistic way to put it, is that Beta is a measure of riskiness. What Beta is doing is calculating the correlation of movement between a stock and the market.
It should be noted that the time frame you use for gathering your data will impact the value you get for beta.
FORMULA:
The resulting number for beta is commonly put on a range from -1 to 1 or greater. A beta with a value of 1 means that the stock is highly correlated with the market’s movement although will not be exact. A beta with a value of 0 means that there is no meaningful correlation between a stock and the market. Finally, a beta with the value of -1 means that the stock is highly negatively correlated with the market, if this is the case the stock should perform closely opposite to how the market performs.
Beta and Riskiness?
In-depth:
For investors, beta can be used as a tool to gauge the systematic risk a stock brings to their portfolio. Generally, there are two types of risk which are described below:
- Systematic risk or market risk is the risk that every company in the market is susceptible to. Examples of this could be interest rate increases (higher interest rates company values go down), Federal taxes, the strength of the economy. This type of risk cannot be diversified away.
- Unsystematic risk or firm-specific risk is the risk which only belongs to a specific firm or a few firms. For example, Uber’s bet on self-driving cars is a firm-specific risk, if they misjudge the cost vs payoff for developing self-driving cars or it takes too long to develop them or on top of that, they get them developed and discover people will not use them then that risk of failure is only on the firm Uber and possibly a few firms depending on them.
Clarifying Beta and Risk:
Let’s say you are looking at a company with a beta of 1.34, what is this telling us? A beta of 1.34 is suggesting the stock is 34% “more risky” than the market but we should clarify risk a bit more in our case. Risk in our case is this stock has been 34% more volatile than the market has been, it could be higher or lower. Something to consider is if you are looking to outperform the market then you would obviously need to perform differently than the market, so, this could be a good risk.
Another company could have a beta of .9, this would be suggesting that the stock is “less risky” than the market, more precisely, the stock is less volatile than the market as a whole. However, just because a stock has a lower beta doesn’t mean a better investment. This stock could be consistently losing value over time and simply moving less than the market.
Bottom line, beta is only a statistical tool to help describe systematic risk in a stock and should not be the only tool used to judge an investment. Risk can be good and bad but in terms of beta, it is merely the probability of getting a return different from our benchmark. In our case, this is the market (S&P 500).
Beta and CAPM?
A big use of beta is in the Capital Asset Pricing Model (CAPM) which is used to calculate the expected return for an investment basis its riskiness. If an investment is more risky an investor will demand a greater return for their investment. How to calculate expected return is of great debate among investors, however, CAPM is widely used as a starting point.
FORMULA:
This is the basic formula for the CAPM, investors will add their own variations to get more specific or “better” results for the expected return. A few things to note here:
- Expected return can also be called the discount rate and is the rate of return an investor should theoretically expect for a certain level of risk
- The risk-free rate is an asset that the investor knows the exact return for the given time horizon. Normally the 10yr US treasury is used for this
- The expected return of the market can be found by identifying how well the market has performed over a longer period of time
- Market risk premium is the premium investors expect for investing in the market instead of the riskless asset.
More on CAPM can be found on our articles about CAPM
Where to find Beta
Already calculated beta can be found on many online stock data sites, we’ve included a list of a few sites below.
It should be noted that if you change the timeline for the historical data you are using to calculate beta the value you get will be different. So, if you use an already calculated beta from one of the above sites you are using whatever timeline they use which can impact future calculations.
Calculating yourself you can have more granular control of the figures you use by calculating beta yourself. To do so you would apply the formula we’ve displayed above. What you will need to do is determine the timespan you want to inspect (1, 3, 5 years, etc.). You will then gather stock price information for that time period which you can do at the sites we’ve listed above by using the “Historical Data” tab.
Next, you will need to find the correlation between the stock you are looking at and the benchmark (S&P 500). Then find the standard deviation of returns for both the stock you are looking at and the benchmark. Once you have that information, divide the stock’s standard deviation by the benchmark’s standard deviation and multiply by the correlation value you have, the result will be the beta.