When investors are looking at putting their money in equities, they need to consider whether the stock's risk profile matches their tolerance for risk. Does the expected return justify the stock's level of risk, or are the stock's price movements too volatile for comfort?
One way to gauge a stock's riskiness is to look at its beta coefficient..
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What Beta Means
Beta measures a stock's price volatility in relation to price movements in the overall stock market. It is measured relative to a benchmark market index such as the S&P 500 and the NASDAQ.
A stock with a beta coefficient greater than one is considered riskier than the broader market. This indicates the stock's price movements would fluctuate greater than the overall market. For example, a stock with a beta of 1.2 means that its share price would be 20 percent more volatile compared to the market.
Stocks with lower betas that are less than one are considered more stable and less risky because their price fluctuations are less than the market's. Including a stock with a low beta will reduce the overall risk of your investment portfolio.
Stocks that have a beta value of exactly one means that the stock price moves in lockstep with the market. The disadvantage is that stocks with a beta of one don't present the investor with the possibility of making returns in excess of the systematic market return. The investor could do just as well by putting their money in a mutual fund that mimics a stock market index rather than taking the risk of investing in individual stocks.
For a beta to be useful, it must be compared to the right benchmark index. For example, it would make sense to compare a large corporation's stock price with movements in the S&P 500 index, but it wouldn't make sense to compare the price movements of bond exchange-traded funds (ETFs) to the same index. Bonds and equities have different investment and price characteristics and can't be compared to the same benchmark.
Consider also: Advantages and Disadvantages of Investing in Stocks
What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) explains the relationship between the risk of investing in a stock and the expected return. The expected return consists of a risk-free return (usually the yield on a 10-year U.S. treasury bond) plus the market systematic risk, plus a risk premium indicated by the beta of that stock..
Investors can use the CAPM to select stocks with betas high enough to give them the desired total expected return.
How to Use Beta
If you're uncomfortable with large price fluctuations in your investments, you're probably a risk-averse investor who is more interested in earning a steady income than scoring a big price gain. In this case, you should stay away from high-beta stocks like tech companies and stick with low-beta stocks such as utilities and banks.
Depending on your risk tolerance and investment strategy, you can use beta analysis to construct a portfolio of stocks with enough risk diversification to suit your comfort level.
Consider also: 6 Characteristics of the Stock Market
Advantages and Disadvantages of Beta
If a company has been in business for three years or more, a beta will have enough data points to give you an idea of how the stock price will move in relation to the market. Beta will give you some insight into a stock's short-term risk profile to analyze its volatility when making a CAPM analysis. However, since beta uses historical data, it's no guarantee that past performance can predict a stock's future price fluctuations.
The beta of a stock can also change from year to year, depending on the growth stage of the company. Betas don't work well with young companies where price movements are more sensitive to news and events about the company rather than an established history of earnings growth.
Just looking at a stock's volatility isn't enough to evaluate its risk profile. You also need to have a thorough understanding of the company's business fundamentals, its financial statements, and other metrics that show the financial health of the business.