Beta is a measure used to gauge how volatile a stock or portfolio has been in comparison to the wider stock market.
The market that it is compared to will vary, depending on the stock or portfolio you are looking at. If you were looking at a portfolio of British stocks, for example, you might use the London's mid cap market as your benchmark of comparison.
Volatility refers to how much and how rapidly a stock fluctuates in value. A stock that experiences large dips and dives in its stock price is more volatile than one that remains at approximately the same value.
Understanding how volatile an asset is by calculating beta is useful for investors because it lets them see how much risk they might be taking on by investing in that asset.
Understanding the numbers
The key figure to remember when it comes to Beta is the number 1.
1 is a baseline figure that represents the performance of a wider market.
If beta is greater than 1, it means that a stock was more volatile than the market.
If beta is less than 1, it means that a stock was less volatile than the market.
For example, the beta of Tesla’s stock from the beginning of 2015 to the end of 2019 was 1.067. That means Tesla was more volatile than the wider market, which in this case was the S&P 500 index.
How useful is beta?
Like all statistics, a beta number can tell you one thing but has the potential to hide other meaningful pieces of information.
Understanding how volatile a stock was in relation to the wider market is useful because it can give you a rough idea of how risky an investment that stock is.
On the other hand, movements in the wider market are largely influenced by large-scale events. A recession, interest rate changes or fluctuations in currency values all affect the market as a whole.
Beta is useful at telling you how sensitive beta has been to these large-scale events. But it doesn’t tell you much about the unique problems a company might face.
For example, a ban on gambling would have a dramatic effect on online betting companies but it would probably have no impact on a biotechnology firm.
Beta is less useful for analysing problems like this. With that in mind, remember that beta is one of many metrics that can be used to analyse the markets. It’s better to use these metrics in conjunction with one another than to see one as being supreme above all others.
Learn more about risk management:
When diversification is dangerous
Ten (+1) investment principles
5 things you shouldn't do when investing
