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Using and Misusing the Beta Ratio

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Do you know your stocks’ beta?

If you do, what does it mean and should you be concerned?

Beta is one of the most used and misused of the financial ratios. First off, let’s review what a beta is, then look at how you can use it in a meaningful way.

The beta is a measure of a stock’s price volatility in relation to the rest of the market. In other words, how does the stock’s price move relative to the overall market.

Beta Calculated

The number is calculated for you (thank goodness) using regression analysis. The whole market, which for this purpose is considered the S&P 500, is assigned a beta of 1. There is no single index used to calculate beta, although the S&P 500 is probably the most common proxy for the market as a whole.

Stocks that have a beta greater than 1 have greater price volatility than the overall market and are more risky.

Stocks with a beta of 1 fluctuate in price at the same rate as the market.

Stocks with a beta of less than 1 have less price volatility than the market and are less risky.

Beta and Risk

Of course, there is more to it than that. Risk also implies return. Stocks with a high beta should have a higher return than the market. If you are accepting more risk, you should expect more reward.

For example, if the market with a beta of 1 is expected to return 8%, a stock with a beta of 1.5 should return 12%. If you don’t see that level of return, then the stock is not a good investment possibility.

Stocks with a beta below 1 may be a safer investment (at least by this one measure) and you should expect a lower return.

Beta seems to be a great way to measure the risk of any stock. If you look a young, technology stocks, they will always carry high betas. Many utilities on the other hand, carry betas below 1.

Finding Betas

You can also compare a stock’s beta to its sector to get a picture of whether the stock is out of line with its peers.

You can find a stock’s beta through a number of online services such as offered by Reuters.

You have to register (it’s free) to get to the level of detail where you can find a stock’s beta among the listed ratios.

Problems with Beta

While the may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.
  • Beta looks backward and history is not always an accurate predictor of the future.
  • Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts.
  • Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.

How to Use Beta

Investors can find the best use of the beta ratio in short-term decision-making, where price volatility is important. If you are planning to buy and sell within a short period, beta is a good measure of risk.

However, as a single predictor of risk for a long-term investor, the beta has too many flaws. Careful consideration of a company’s fundamentals will give you a much better picture of the potential long-term risk.

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