People who are interested in stocks will have seen the term "beta" being used here and there. Unfortunately, said term doesn't provide much context for interested individuals to figure out what it might mean. Even worse, beta is so common that most people using it don't feel the need to explain it, thus leaving interested individuals even more confused.
For those who are curious, the beta is a measurement of an investment's volatility under certain circumstances. To be exact, it measures the tendencies of an investment's return to change in response to changes in the market as a whole. As a result, an investment portfolio representing the market as a whole should have a beta of 1, whereas other investments can cover a rather impressive range of numbers. Generally speaking, a beta between 0 and 1 means that an investment is less volatile than the market as a whole, whereas a beta that is bigger than 1 means that an investment is more volatile than the same. Theoretically, even negative betas indicating an inverse relationship with the market as a whole are possible, though there is some contention over whether gold and gold stocks can actually be considered as having negative betas. Likewise, it is possible for a beta to go as high as a 100, but in practice, that shouldn't happen because the investment would go to 0 upon the slightest decline in the market as a whole.
What Does Beta Mean for an Investment?
The beta is but a single measurement, meaning that interested individuals shouldn't base their evaluation of an investment based on it and nothing else. Something that can be said for all of the other measurements that can be found out there. Regardless, the beta says a lot of useful things about a stock.
For example, a low beta could mean that an investment has low volatility when compared to the market as a whole. However, it could mean that an investment is volatile, but that its volatility has little connection to the market as a whole. For example, the stocks of utilities tend to have low betas. Meanwhile, gold and gold stocks often have low betas as well because their price movements are not necessarily connected to the movements of the market as a whole. Compared to these examples, a high beta is interesting because it indicates an investment isn't just more volatile when compared to the market as a whole but also has its movements connected with the movements of the market as a whole. Fast-paced tech stocks tend to have high betas, though bigger and better-established tech stocks shouldn't be seeing betas higher than 4 because of their bigger and better-established nature in their chosen sectors.
Having said this, neither a low beta nor a high beta should be considered a bad thing on its own. Instead, a low beta indicates that an investment should be less volatile, which means a smaller chance for higher than expected returns but also a smaller chance for lower than expected returns. Meanwhile, a high beta means increased risk, which can turn out well but can also turn out not so well. As a result, interested individuals will need to use the beta in the context of other measurements to get a full picture of the investment before judging its merits based on their own investment priorities. This is particularly true because interested individuals need to remember that an investment's bet is based on historical data. As a result, the current beta of an investment is not necessarily a good indicator of what an investment's beta will be like in the future, thus making it even more incomplete when used to gauge an investment overall value.
With that said, it is important to note that the beta is interesting in one other sense as well. In short, it is an indication of the risk of an investment that can't be eliminated through the practice of portfolio diversification, which sees use for excellent reasons. As a result, it can be considered a measurement of the risk that will be added onto an existing investment portfolio that has already been diversified for the purpose of avoiding the all eggs in one basket problem. Something that people looking to minimize their investment risks should consider when looking at potential investments.
Written by Garrett Parker
Read more posts by Garrett Parker