Investors are often overwhelmed with a plethora of numbers when considering how to invest their money. A stock or mutual fund's beta measures how the stock tends to respond to market movements -- both positive and negative. Picking stocks with a range of betas can help you diversify your portfolio.
Beta measures the fluctuation of a stock or a mutual fund relative to the larger market, which is typically measured by an index such as the S&P 500. Since the market is the benchmark, the market's beta is always 1. When a stock or a fund has a beta greater than 1, it means the stock is expected to increase by more than the market in up markets and decrease more than the market in down markets. For example, a beta of 1.05 means the stock is expected to rise 5 percent more than the market on a good day or fall 5 percent more than the market on a bad day. Conversely, a stock with a beta of less than 1 is expected to rise less than the market on a good day, but fall less than the market on a bad day.
While rare, some stocks do have a negative beta, which means the stock moves opposite the general market trend. For example, say that a stock has a beta of negative 0.8. That means that instead of increasing by 80 cents every time the market goes up by $1, the stock actually goes down by 80 cents. However, if the market goes down by $1, the stock is expected to rise by 80 cents.
You can't calculate beta with a pen and paper, but that doesn't mean its calculation has to remain a mystery. Beta is figured based on how closely the stock or mutual fund's returns match the market's returns, and how the standard deviation of the stock or fund's returns compares to the market's returns. The standard deviation measures the volatility of each set of returns, so if the stock's returns vary significantly when the market also varies significantly, that leads to a beta closer to 1.
A beta number doesn't tell you how volatile an individual stock is -- just how it moves relative to the market. A stock with a low beta could mean that the stock is very stable regardless of how the market is moving, or it could also be incredibly volatile relative to the market. In addition, a stock or fund's beta isn't set in stone. Instead, it's based on past performance, which, as investors know, doesn't guarantee future performance.
- Duncan Smith/Photodisc/Getty Images