Selecting the proper investments for your situation is one of the most difficult aspects of financial planning – especially if you’re new to the game. After all, if you buy a stock that is too risky, you could lose your entire investment. On the other hand, if you aren’t taking enough risk for your situation, you could leave money on the table.
Fortunately for investors, there is a standardized measure designed to help you estimate the level of risk associated with a stock and project how its price should react to certain circumstances. This metric is a stock’s Beta (β).
What is a stock’s Beta?
A stock’s Beta – also called the Beta Coefficient and often denoted by the Greek letter β – is a measure of price volatility or fluctuation compared to a benchmark. The benchmark could be another stock, a sector, or the overall market.
The most common benchmark used for calculating Beta for stocks is the S&P 500, as it is considered an effective representation of the stock market as a whole. Beta is most commonly used in fundamental analysis and when building diversified portfolios.
How to Calculate a Stock’s Beta
You could use calculus to measure the strength of the correlation between the stock’s historical prices and those of a benchmark, thus determining Beta, but that is complicated. Fortunately, you don’t have to do this. A stock’s market Beta is so widely used that it can easily be found online for most stocks (no calculations required).
Many websites that provide stock quotes, such as Yahoo Finance, Barron’s, and CNBC, list the stock’s Beta along with other statistics. All you need to do is search your preferred website for the stock’s ticker symbol and locate its Beta with other performance information.
How to Interpret a Stock’s Beta
Once you’ve found a stock’s Beta, you need to know how to interpret it. To do this, there are a few things you need to know. First, the benchmark’s Beta is always 1. Second, the most commonly used benchmark for general analysis is the S&P 500 which represents the overall market. Finally, the following bullet points will help you understand what the different values of Beta represent.
- β > 0: A stock with a positive Beta is expected to move in the same direction as the market. If β = 1, the stock is expected to move at the same pace as the market. If β > 1, the stock is expected to move in the same direction as the market, but at a faster pace.
- β = 0: A stock with a Beta of exactly 0 would not be expected to react to changes in the overall market.
- β < 0: A stock with a negative Beta is expected to move in the opposite direction as the market. If β = -1, the stock is expected to move at the same pace as the market, but in the opposite direction. If β < -1, the stock is expected to move in the opposite direction as the market, but at a faster pace.
Of course, if Beta could accurately predict the precise movements of a stock, there would be no need for other measurements. Instead, Beta can only provide a quick overview of a stock’s historical price movements. It is not a perfect indicator of how a stock will perform – relative to the overall market or otherwise – and it has important limitations you should understand before you use it to make investing decisions.
Limitations of Beta
Like other ratios used to evaluate stocks, Beta is based on historical information. Therefore, it doesn’t tell you what a stock will do, only what it has done in the past. For example, if a company started taking larger risks – and experiencing bigger swings in its stock price as a result – it’s Beta could be an inaccurate indicator of future performance. However, Beta would become more valuable after additional data was available reflecting the company’s new strategy.
Another limitation of Beta is that it can only be calculated for companies that have historical performance information. New companies, or firms that have recently gone public, often don’t have enough historical data to calculate Beta.
A final limitation of Beta is that it only measures one type of risk – systematic. This type of risk is also called market risk because it measures risk that applies to the entire market. Beta doesn’t account for other types of risk like that which effects only one sector or one business. Beta also does not account for the health of a company measured by factors like earnings, cash flow, and debt.
These limitations don’t mean that Beta isn’t valuable. You can still use Beta in your investing decisions, but it alone is often not enough to evaluate a potential investment.
How to Use Beta in Your Investing Decisions
Beta can be used as a complement to stock research and your individual goals to help you determine if a stock’s risk profile fits into your portfolio. Before you begin researching stocks, you should first have a clear understanding of your investment objective. Your personal financial situation, risk tolerance, and goals determine your objective and which types of investments are suitable. Once your objective is established, you can choose investments based on thorough research and a comprehensive understanding of the markets.
Stock research often begins with reviewing current trends and market news to determine which sectors are expected to grow. Then, ratios like Earnings Per Share, Debt to Equity, and Return on Equity can give you an overview of a specific company’s financial position. Once this research is done, you can use Beta to complement it.
Fortunately, an experienced wealth manager can take this work off your plate. An advisor can help quantify goals, determine an appropriate amount of risk, and choose investments to help meet your investing objective.
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If you want to invest in stocks, but don’t have the time or experience to compare the performance ratios, Betas, and financial position of each company, DreamWork Financial Group can help. Our unique wealth management plan, Investing Gameplan™ allows you to access fiduciary advice and a custom portfolio of ETFs and individual stocks that match your risk tolerance and goals.
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