What is a stock’s beta?
A stock’s beta is the measure of its volatility in relation to the overall market. To calculate beta, individual stocks are ranked against a benchmark to see how much they deviate from the average.
Normally, a beta of 1.0 is assigned to a benchmark, such as the S&P 500, and then stocks that swing higher than 1.0 are more volatile, and stocks less than 1.0 are less volatile.
Beta is a useful metric for both traders and investors who are looking to make decisions about which stocks to buy and sell. Traders in general will tend to focus on higher volatility assets, to take advantage of short-term market movements.
For investors, shorter-term market movements aren’t of much interest, so it will depend on their individual attitude to risk: stocks with a higher beta tend to come with higher risks but have higher returns.
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Differences between stock beta and alpha
Both beta and alpha are means of measuring a stock’s historical performance against a benchmark. While beta tells us how volatile a stock’s price has been, alpha measures whether it has outperformed or underperformed.
Although both are shown as a single number, like 1.5 or 2, the figures indicate very different outcomes. While a beta of 1.5 means a stock has been 50% more volatile than a benchmark, an alpha of 1.5 tells us the stock has outperformed a benchmark by 1.5%.
Most traders and investors will consider both beta and alpha when making decisions about the risk and reward of a stock. If a stock with a high beta fails to produce any alpha – any returns against a benchmark – then they might decide that the excess volatility risk isn’t worth the reward.
What are high-beta-value stocks?
A high-beta-value stock is one that has a higher rate of volatility than the benchmark it’s measured against. You might say a beta of 2.0 is high, as it means the stock moves twice as much as the market. But really, there’s no one definition of ‘high beta’ as it’s completely dependent on the industry, and index in question.
High-beta stocks come with higher risk but typically outperform the benchmark during periods of rising prices. However, this means that in bear markets, high beta stocks can experience larger-draw downs.
High-beta stocks are often found in cyclical industries that move with the boom and bust market cycle – such as consumer discretionary, financials, and materials.
For traders, the volatile nature of high-beta stocks makes them appealing as derivatives can be used to take a position whether the share price is rising or falling – creating more opportunities.
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For investors, high-beta stocks can be concerning given the risk of holding them through a downturn. But ultimately, the decision comes down to the risk profile of the individual. As we’ve mentioned before, they’ll have to weigh up whether the risk of outsized returns outweighs the risk of outsized loss.
What are low-beta-value stocks?
Low-beta stocks exhibit lower levels of volatility when compared to the benchmark they’re measured against. A low beta value is typically anything less than 1.0.
While low-beta stocks don’t come with the outsized returns that high-beta stocks offer in bull markets, they tend to outperform over the long term due to consistent returns in all market conditions. That’s why low-beta stocks are the choice of buy-and-hold investors, not short-term traders.
Companies that have the lowest betas are often found in industries such as consumer staples and utilities, which are considered defensive stocks in that they perform well regardless of the state of the economy.
So, it’s important to consider the current environment before making decisions. For example, during the coronavirus pandemic, low-beta stocks underperformed consistently. According to research by BlackRock, the strong market performance that followed the 2020 equity market crash saw the S&P return 50.9%, compared to 29% for the iShares MSCI USA Min Vol ETF.
What does a negative beta stock mean?
A negative-beta stock is one that has a value of less than 0, which would indicate that it has an inverse correlation to the benchmark it’s measured against. It’s rare that a stock moves in opposition to the market, but not impossible.
There are a few industries where negative betas are more common, such as gold miners, as gold stocks tend to do better when the market declines. Negative-beta stocks are a popular part of diversification strategies, as they provide a means of hedging against declines in other stocks.
How to calculate the beta of a stock
To calculate the beta of a stock, you’d divide the covariance by the variance of the return of the benchmark over a certain period. Typically, beta is calculated using spreadsheet programs or online beta calculators because it requires multiple data points, and manual calculations can get complex.
But for those that want to calculate beta themselves, the formula looks like this:
Beta = covariance/variance
To calculate the covariance, you’d find the difference between the return of the stock and the return of the index. Normally, you’d use the closing price for each day over a given period to find the returns and calculate the average for each.
Covariance = (Sample Size) − 1∑(Return of stock – Average return of stock) ∗ (Return of benchmark – Average of benchmark)
Covariance is a measure of how correlated the two variables are. So, a positive covariance means that the stock and benchmark move together, whether that’s up or down, while a negative covariance means they move in opposite directions.
The variance equation represents how much the benchmark index moves relative to its own mean. It’s calculated as the weighted sum of the square of differences between each outcome and the expected returns.
Variance = SUM (RET DEV)2/N
- SUM = Summation notation (the sum of all the returns values)
- RET DEV = Actual returns deviation over selected period
- N = Number of points for the period
Say you’re looking to compare the beta of Tesla to the S&P 500. Based on data, you find that over the last five years, Tesla and the SPY have a covariance of 3.5, while the variance of the SPY is 1.72.
This means Tesla would have a beta of:
3.5/1.72 = 2.03
This means that theoretically, Tesla is 103% more volatile than the S&P 500 (1-0.047).
How to trade stock market volatility
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