What is Beta in Stock Trading?
The stock market can sometimes feel like a wild, and even sickening, ride. Beta can help calculate the nausea.
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Do you want your portfolio to be more stable?
Of course you do—we all do.
But the fact of the matter is that investors can benefit from the market’s volatility. 📈
Importantly, volatility is normal for the stock market and it’s what enables traders to earn a profit. But when you see volatility get out of control and investors drive assets to unstable levels, you may feel the need to adjust your portfolio to your risk tolerance. The metric that investors use to limit (or increase) their risk is beta.
In this article we will teach you what beta is and how it can be used to adjust your portfolio. We’ll go over why beta can be a powerful tool to analyze risk, and some of the downsides that come with relying too heavily on it.
Sound good? Let’s go! 🚀
- Beta Defined
- Understanding How Beta Works
- Calculating Beta
- Why Beta is Important for Stocks
- Stocks with a Low and High Beta
- Factors Other Than Beta
- Alpha Explained
- Low-Beta Assets During a Recession
- An Example of Beta
- Pros and Cons of Beta
- Risks of Using Beta
- Beta FAQs
Beta Defined 📚
Beta is the volatility of an asset compared against a benchmark. When we are talking about stocks, the benchmark is normally the S&P 500. Because the S&P 500 is an index of the 500 largest companies in the US, it gives a solid figure to understand what normal returns and volatility should look like.
The beta of a stock illustrates how risky an asset is compared to the market. Beta can also tell us if an asset isn’t correlated to the benchmark whatsoever, or even if it’s negatively correlated.
All of these factors show how risky a portfolio is when compared to the market as a whole. A riskier portfolio has the potential for higher gains, but of course, the possibility for more losses.
Understanding How Beta Works in Stocks 🧠
To better understand what beta means, we are going to need to look at some numbers. The average beta is 1; 1 represents the average return of the whole stock market.
We compare assets against a beta of 1 to understand how they stack up on the market. There are 5 different categories; let’s start with the high numbers and work our way down.
Beta > 1
If a stock’s beta is greater than 1 then it is riskier than the overall market. In a bull market—fingers crossed that we are in one—these stocks are going to gain more for every increase in the market, and in a bear market, they will lose more for each decrease.
Stocks with a Beta greater than 1 are often tech stocks. For example, AAPL has a beta of 1.27. This means that for every dollar the S&P 500 moves, AAPL will move an additional 27%.
Beta = 1
Stocks with a beta of one are perfect mirrors of the overall stock market. These will often be ETFs or index funds that track the market. SPY, the ETF trust, has a beta of 1. Some ETFs are even taking advantage of beta to improve gains.
Beta from 0 to 1
When beta falls below one and towards zero you get the interesting situation where the asset correlates less and less with the overall market. These are normally going to be robust industries like utility companies. They could also be global companies that grow in many different markets. Two such companies are Dominion Energy (D) that has a beta of 0.35, and PepsiCo (PEP) that has a beta of 0.61.
Beta = 0
When beta reaches zero we will have assets that are not related to the market whatsoever. Some people like to call cash a 0 beta asset because it won’t change no matter which way the market goes.
Beta < 0
We’ve descended to the bottom of the beta slopes of madness. Here we have assets that are negatively correlated with the stock market. In a bear market, these stocks will rise. In a bull market, they’ll fall.
Beta = 0.0
0.0 beta doesn’t really exist. If you see a financial service saying an asset has a 0.0 beta, it’s likely because the asset is new, and the information is not yet available.
Calculating Beta ➗
If you’re a stock geek like us, you’re probably wondering “how can I perform this Beta Calculation?” 🤓
Well it’s pretty easy, you’ll just do this:
If you’re not a math wiz and didn’t get your graduate degree in statistics, let’s go over what all of these variables mean.
| Variable | Definition |
|---|---|
| 𝜷 | The Greek symbol for beta. |
| rp | The return on a stock. |
| rb | The return of the overall market (benchmark). |
| Cov | Covariance - how a change in the stock’s return correlated with the market’s return. |
| Var | Variance - How far the market’s data spread from the average value. |
Knowing how beta is calculated gives you important insight into the way benchmarks work. The closer your stock is related to the underlying benchmark, the better beta can be in determining risk.
Why Beta is Important for Stocks ❗
Many investors use Beta as an important metric in understanding how risky their portfolio is. If an investor made a lot of money on the stock market, or maybe lost some money, they may want to transition into a less volatile portfolio. Investors in retirement may also be more concerned about maintaining a stable portfolio than growing their assets.
Beta can help investors limit volatility when it gets excessive, like it has been during most of the COVID-19 era. This can also help lower risk. Although many professionals will say that a low beta does not preclude an investor from risk.
Just because a stock’s beta is low does not mean that you will not lose money. Stocks could be on the steady downward trend, but if the stock doesn’t make large swings the beta can still remain low. You will still lose money, just not all at once.
Another way that investors can use beta is by increasing the risk of their portfolio. If your assets haven’t increased in value very much, you may have less volatile and less risky stocks. It can be beneficial for some investors to take on more risks to improve their gains.
Where to Find the Beta For the Stocks You Like 🗺️
Depending on your broker, you may find beta statistics through their site. Some of the top stock brokers include this information along with other metrics that help you understand a company.
There are other places online that you can find stock betas for free. One popular tool is Yahoo Finance which also allows you to screen stocks based on beta.
You can even find beta numbers on popular stock trading apps. With all of these sources, you just need to look in the financial information sections.
Stocks With a Low and High Beta ↕️
To better understand how beta works, we can look at some real-world examples. Generally, when we are thinking about boring, stable companies like blue-chip stocks or index funds, they are going to have a low beta number. This is because the potential for growth is either much slower than the stock market—which is the case for utility companies—or they are going to match the market.
Low Beta Stocks
With low beta stocks, you will see the company follow the overall trend of the market, but the gains and losses will be less severe. Dominion (D) has a beta of .35.
Comparing it to the market illustrates the lower volatility of the stock. Utility companies are low volatility stocks because their potential for profit is often capped by government regulation due to the nature of the company.
High Beta Stocks
On the other hand, high beta stocks are going to amplify trends in the market. Some high beta players have traditionally been in the technology sector. Apple and Facebook are both companies with high beta.
Apple and Facebook have betas of 1.27 and 1.26 respectively, and you can see how they have extended gains and losses as the market has moved over the past five years. High volatility can improve gains in a bull market, even though high-beta stocks crash harder during a recession.
Considering Factors Other Than Beta 💡
Because beta does not try to predict what a company or asset will do in the future, and it does not attempt to account for an asset losing you money—rather just how volatile the asset is—we are starting to see the cracks in the wall. There are some major points investors need to be aware of with beta.
These aren’t necessarily problems with Beta. It’s clear that Beta is a useful statistic for understanding how assets relate to the overall market. Where investors get into trouble is when they start using beta to understand other aspects of a company.
Beta does not tell you anything about the fundamentals of a business. You will not understand the debt to equity ratio from looking at a beta chart and you will miss out on other important factors. In some cases, knowing how much bitcoin a company has can give you more information than the stock’s beta.
If a stock suddenly drops in price because of a reaction to something on the market, the beta could go up. But this might only be from temporary news and it really doesn’t get at the underlying picture of the company. You need to understand a corporation’s management, cash flow, and what the rest of the sector looks like.
These are better metrics to figure out whether you should buy an asset or not. Beta alone is not useful at understanding the fundamentals. It will only help you decide if the stock is volatile or not.
Alpha Explained 🛠
Alpha is a tool that we use along with beta to better understand an asset. Alpha is represented by the greek character ɑ and it helps investors understand how well an asset has performed against a benchmark.
It is common to use the S&P 500 as the benchmark. Alpha will be expressed as a number representing the percentage of deviation from the average market returns. For example, +10.0 would mean an asset performed 10% better than the market average.
Using Alpha in combination with Beta will help calculate the risk versus reward for gains or losses. This can allow investors to calculate whether or not the risk was justified.
Low-Beta Assets During a Recession 📉
There are different types of risk in the stock market. Some risks you won’t be able to do much to avoid. These are called systematic risks and include things like a market crash. No matter how much you diversify your portfolio, if the whole market tanks, you are going to see your value shrink.
On the other hand, sometimes when markets retract, there are stocks that negatively correlate with the S&P 500. Negative beta investments could be things like shorted ETFs such as the ProShares Short Dow30 (DOG) which has a beta of -0.88. Negative beta stocks can be helpful assets to grow your portfolio even during downturns. This is a great technique for those learning to short sell.
Other industries are going to be better insulated from crashes altogether. These might be global companies that have markets all around the world, and they are better protected from one country’s economic troubles.
Robust blue-chip companies and utility companies may have reduced losses during crashes just because they are so big, have cash reserves, low debt, and will probably be high up on the list if the government wants to start handing out bailouts. Lower betas can help investors keep value during downturns—this is one of the reasons investors are bullish on energy stocks when there is a recession on the horizon.
Example of a Successful Beta Prediction ✅
Now that we’ve gone through the good, the bad, and the ugly of beta. Let’s talk about how we can use beta to improve short-term gains.
Beta is often used by traders to better evaluate the market. If you are learning how to day trade, you will know that volatility can improve profit. Working with increasingly volatile stocks, you can find companies that have higher or lower betas to improve gains.
Let’s look at Tilray as an example—you may have seen this stock in the news lately because of a Reddit-driven rally. Looking at the beta, it may have been possible to predict the spike as we saw the beta increase to 1 and beyond. We know that betas in excess of 1 will have higher returns than the overall market.
With that in mind, it’s possible for traders to improve their day trading by following stocks with higher than average betas. Traders can also hedge their trades by looking at inverse and shorted stocks.
Pros and Cons of Beta in Stocks
Using beta to predict an increase in stock price is a solid advantage, but there are plenty of downsides. It’s important to understand that beta helps fill in some information on a company, but it doesn’t provide all the information.
Pros
- Beta can help you quiet down a portfolio that is outside of your preferred risk tolerance.
- You can use beta to prepare for economic downturns.
- Beta helps you understand the history of a stock before you buy it.
- You can better understand how your portfolio will fare against the market overall
Cons
- Beta is not going to account for long-term changes. The volatility of a company can change over time so the beta is better for short-term investments.
- You have to look at other metrics along with beta to get the whole picture on a stock.
- You can get a bad asset because beta doesn’t account for the thing we traditionally associate with risk (i.e. losing all your money).
Risks of Using Beta ⚠️
Inexperienced traders may rely too heavily on beta because it seems like it accounts for a lot of information. It sounds like a very powerful statistic, but it needs to be used in tandem with other metrics.
Beta can also be misleading because it only accounts for historical data. It does not predict where the market will go. Investors looking to reduce risk need to screen stocks by evaluating the underlying company.
As always, there are scams to be aware of. If you have a micro-cap stock, every trade is going to impact beta. If you don’t have millions of outstanding shares, you don’t get the whole picture of beta on a company. This can also happen when the volume of a company is low.
Beta in Stocks: FAQs
-
What Does a Negative Beta Mean in Stocks?
In stocks, a negative beta means that an asset is inversely correlated with the overall market. This means that when the market falls, the asset will rise and vice versa.
-
What is Alpha and Beta in Stocks?
Alpha and beta are two common indicators used to determine the riskiness of an asset. Alpha is used to calculate how much a stock gained or lost compared to market averages. Beta shows how an asset correlates with the stock market.
-
What are High Beta Stocks in NSE?
Because high beta stocks change frequently in the short-term, it’s best to use stock screeners to identify high beta stocks. Some high beta stocks currently include the State Bank of India at a beta of 1.09 and ICICI Bank Limited at a beta of 1.11.
-
Why is Beta so High in Oil Industry Stocks?
Beta is high in the oil industry because they are more volatile than the market in general. This is because of the speculative nature of oil stocks.
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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.
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