Beta is a measure of how volatile a particular investment is compared to the stock market as a whole. A higher beta by definition means more volatility, which can also mean greater risk and the potential for greater reward. A negative beta stock generally moves in the opposite direction from the rest of the stock market.
Beta signifies the volatility of an investment and is thus a helpful indicator of risk for investors to use. However, it should be used alongside other indicators.
Beta in the Stock Market
Beta in finance, represented by either the word or the Greek letter β, is a term used to refer to the volatility of a particular investment, such as a stock, meaning how it fluctuates compared to the market as a whole. It's usually computed by comparing historic market fluctuations to something that captures the whole market, such as the Standard & Poor's 500 Index of major U.S. stocks.
A beta value of 1 indicates that a particular stock is exactly as volatile as the index used for the comparison. A beta value between 0 and 1 indicates that the stock is less volatile than the market as a whole, and a value greater than 1 indicates more volatility. A beta value of 0 means the stock's performance is uncorrelated with the market.
You may also see beta values below 0, indicated with a negative sign. This means that the stock has a tendency to move in the opposite direction from the market as a whole.
Using Beta to Invest
Beta is one of many tools you can use to determine whether you want to invest in a particular stock. A high beta stock could be a sign of a good but risky bet, while a low beta value means less risk but the potential for smaller returns. Negative beta stocks might be a good way to offset potential losses from investments that more closely track the market as a whole. In general, beta numbers might be useful information as you design a market portfolio with a mix of safe and high-risk potential investments that suits your needs.
You can often find beta values online through stock news and information sites or brokerage portals, and you can calculate them yourself with an Excel spreadsheet or online calculator tool. You probably won't want to choose investments simply by looking at beta values or any other one number.
Considering Other Factors When Investing
Look at what you can about the fundamentals of a company, how its stock has historically performed compared to others in similar industries and anything that it has released about plans for the future. Look at published news and magazine articles about a business you might invest in and see what it has shared with the public through filings with the Securities and Exchange Commission and other regulators before pulling the trigger on an investment decision.
Also consider your portfolio as a whole. Diversification can be a bit of a cliché, but mixing higher and lower volatility stocks can be a good way to whet your appetite for risk without risking losing all your assets in a market crash. Consider stocks as well as other investments like bonds, mutual funds and even bank products, and think about your investment goals, earnings from other sources and how close you are to retirement in picking investments. Talk to a financial adviser if you need extra help.
Comparing Alpha and Beta
Another Greek letter that can pop up in financial discussions is alpha, also written α. Beta is a measure of volatility, while alpha is a measure of performance relative to the market as a whole. It's often used to discuss how funds and their managers are performing relative to broad indexes like the S&P 500.
Usually, alpha is reported as a percentage above or below an index's performance. For instance, a stock fund with an alpha of 3 delivered investors returns 3 percent better than the S&P 500 over a particular period, while one with alpha of -2 delivered returns 2 percent worse than the S&P 500. Remember that positive or negative alpha doesn't necessarily mean a gain or loss, since it's comparing to the alternative choice of simply investing in the market as a whole. A negative alpha can still be a gain if the market is doing well overall, and a positive alpha can mean a loss if the whole market has taken a hit.
A stock or mutual fund that does as well as the market would generally have an alpha of zero, just as one that has the volatility of the market has a beta of one.
Choosing Low Beta Index Funds
If you're looking for investment funds with predictable alpha and beta, index funds can be a good bet. By definition, they pool investor funds to purchase stocks on the major indexes, like the S&P 500 or the Nasdaq Index. They can charge lower fees than actively managed mutual funds, which need to pay human experts to pick stocks to invest funds in, and they can deliver solid returns and even dividends as long as the market is doing well.
Index funds are available directly from many brokerages and can also be purchased through stock markets as exchange-traded funds. By definition, an index fund should have beta very close to one and alpha very close to 0, compared to the index in which it invests.
Index funds also exist tracking particular sectors of the economy, like energy stocks or telecommunications businesses. Shop around to find funds you like with good results and affordable fees.
Limitations of Alpha and Beta
Alpha and beta can be useful metrics to look at when considering investment opportunities, but it's important to remember they're essentially limited based on the past data that's available. Since market conditions change over time, so too can an investment's performance and volatility, even relative to the market as a whole.
Companies and industries can rise and fall, bringing greater or lesser returns. Newer funds or companies with less data available may not have enough historical results to generate solid alpha and beta numbers.
Remember to take a look at the information that's available besides simply alpha and beta as you consider different investment opportunities.
Watching Out for Scams
Some high beta stocks are low capitalization, or total market value stocks, with a limited number of outstanding shares. Because of low-trading volumes, small transactions can cause their stock prices to change quickly. Many are also penny stocks, which today means any stock trading for less than $5 per share, and some are only available through the less formal, over-the-counter trading system rather than through big exchanges like the New York Stock Exchange or Nasdaq.
These can be attractive to investors looking to put money into fledgling companies in hopes of a big return, but they can also be a target for scammers. Fraudsters will secretly buy low-priced stocks, then promote them online or through other kinds of marketing. When other investors jump in, the price goes up, letting the scammers cash out their holdings for a sizeable profit. This is sometimes known as a "pump and dump" scam.
Watch out for stock tips from relatively unknown sources, and be skeptical of messages on online forums or mailing lists touting particular stocks. Research any investment thoroughly before putting in your hard-earned cash.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.