A beta coefficient is a metric that can be used to evaluate your stock investments. You can use it as an analytical tool to help select stocks that match your risk profile.
What Beta Is
Beta is a metric that shows how much the price of a stock moves relative to price changes in the overall market. It is based on its past historical movements and doesn't consider current earnings reports or any news about the company.
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Beta is an indicator of the volatility of a stock's share price. It does not tell you anything about the company's strengths or weaknesses nor its competitive position within its industry. It only tells you how the stock price reacts to the overall market.
Beta is not necessarily a measure of risk. A high beta does not mean that the stock is any riskier than any other stock. On the other hand, a low beta does not mean a stock is a safe investment.
How Beta Works
The beta of a stock is found by comparing the movements of a stock's price in previous years to changes in a market index, such as the Standard & Poor's 500 index, the Dow Jones Industrial Average or the NASDAQ 100.
Stocks that have a beta less than one are less volatile than the overall market. As an example, a beta of 0.5 indicates that the stock price will move 50 percent as much as the stock market index moves.
Just remember that a stock's beta is based on its historical price movements and is not a prediction of the future.
Stocks that have a beta greater than one will have price movements more volatile than the market. For example, a stock with a beta of 2.0 means its price would move twice as much as the market index. If the stock market index goes up 10 percent, the stock price will increase by 20 percent.
However, the reverse is also true. If the overall market dropped by 10 percent, a stock with a beta of 2.0 would see its price decline by 20 percent. If a stock has a beta of one, its price would move exactly the same as the overall market.
A stock's beta doesn't necessarily stay constant over time. It can change. For this reason, a beta coefficient isn't helpful to project a stock's investment over the long term.
How to Use Beta in Your Investment Strategy
You can use beta as one metric to assemble a stock portfolio that matches your risk profile. If you have a low tolerance for risk and volatile price moves make you nervous, you'll want to focus more on stocks that have betas less than one.
On the other hand, if you have a higher tolerance for price volatility and want to maximize your return, you'll invest more in stocks that have high beta coefficients. Suppose, for example, you're optimistic and believe the overall market will increase by 15 percent in the coming year. If you invested in stocks with beta coefficients of 3.0, you might receive a total return of 45 percent.
Just remember that a stock's beta is based on its historical price movements and is not a prediction of the future. If you're willing to accept the historical price volatility, you could invest your funds for discretionary spending in high beta stocks. This would be only if you don't need these funds for essential expenses.
It might be helpful to take a look at some examples of beta coefficients for several well-known corporations:
- Procter & Gamble (PG) – 0.42
- Target Corporation (TGT) – 1.01
- Home Depot (HD) – 1.03
- Exxon Mobil Corporation (XOM) – 1.43
- Bank of America (BAC) – 1.53
- Halliburton Oil Services (HAL) – 2.85
- Wayfair (W) – 3.09
- Overstock.com (OSTK) – 4.43