Beta: Knowing Which Ride You’re Getting On

Beta: What kind of ride are you signing up for?
Before you get in, you should know what you’re signing up for.

When I was first considering investing in the stock market, one of the things that struck me was that some stocks seemed to chug along relatively steadily, while others rose and fell like some kind of  Fear Factor Ultimate Challenge roller coaster ride. I was looking to make money, not lose sleep, so I was quite happy to forego the highs and lows of certain stocks for the steady-eddies that just kept on keeping on. As a happy coincidence, dividend stocks, which I was investigating at the time, are much more the former than the latter. As my stock research became more focused on the types of stocks that paid stead dividends, I ran across fewer and fewer high flyers. Still, I wondered, is there a way to quantify the volatility of a stock?

The answer is yes, and the number that name that is given to the describing of this characteristic is beta.

Beta

Beta is a number value that describes the degree to which the price action of an individual stock mirrors the direction and magnitude of the price action of the overall market. The market as a whole is assigned a value of 1.0. Beta values are assigned relative to this 1.0 score.

If a stock tends to reach higher highs and lower lows than the market average, then that stock will have a beta that is higher than 1.0 The further a stock’s beta is from 1.0, the more volatile that stock is. A stock with a beta of 2.0 would peak at (roughly) twice the percentage gain that the stock market as a whole peaks on a high, and would fall (roughly) twice as far, again in percentage terms, as the market on a low. Simply put, the higher the beta, the more manic it is.

A stock that moves less than the market as a whole has a value of less than 1.0. The further below 1.0 the stock’s beta is, the less the volatile the stock is, relative to the market as a whole.

Typical examples of low and high betas

Large banks and utilities tend to have low betas because they are the stocks that steady the overall market. Tech stocks tend to have higher betas because they often soar and plummet, introducing more volatility into the market.

Can betas be negative?

It may seem counter-intuitive at first, but yes, betas can be negative. And if you think about it, you can probably see why.

Quick quiz: What is the traditional thing to buy when the stock market is tanking? If you answered “gold”, you already get it. Beta measures the magnitude of stocks’ price movements when they are moving more-or-less in tandem with the overall market. A negative beta score implies that when the overall market is moving in one direction, that particular stock (or asset) moves the other direction. A negative beta simply shows a negative correlation with the overall movements of the market. A beta of -1.0 would have a perfect negative correlation to the overall market. Note that a stock does not “earn” a negative beta because it had gone one way for a week, and the market has gone the other; it takes a much longer period of time than that for a stock’s beta to be negative. (See points below.)

Points about beta to remember:

  • Beta is calculated differently by different organizations. Yahoo Finance uses the past 60 months to calculate its beta. The S&P TXS Composite High Beta Index uses a shorter, 12-month period.
  • A high (or low) beta score is neither inherently good nor bad; it is just a description of how that stock has preformed relative to the overall market for a fixed amount of time.
  • This bears repeating: Beta describes a stock’s movement relative to the rest of the market, not to an absolute standard. If the market is going through turmoil, a stock with a beta of 1.0 will go through exactly the same amount of turmoil; a stock with a low beta will go through less, but will not escape altogether. A stock with a high beta will mean you may want to stock up on Pepto-Bismol.
  • There are time when certain investors look to move from high to low betas, or vice-versa. If you think markets are about to tank, low betas are good. If you’re expecting a big run-up, you will want to move money into high beta stocks to take advantage of the above-average returns available. (I don’t invest like this, but I have to admit it is tempting to try from time to time.)
  • Keep in mind that betas are nothing more than numerical descriptions of past event. There is absolutely no way to be sure that the future will echo the past. That’s why they call them “surprises”.

Finally, and most importantly, remember that beta is just one piece of information in a veritable sea of numbers, ratios, and Greek letters. None of these is sufficient as a sole basis on which to make investing decisions. Beta is just one more piece of the puzzle. I chose to include it on LoonieLover because I find it useful as a primary screener when I’m looking at a stock. I like being able to qualify a stock’s past volatility in an easily-understood and easilty-comparable number.

 

 

 

 

 

 

 

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