In the stock market, the word or Greek letter beta is used as a measurement of the riskiness or volatility of a particular investment relative to the market as a whole. If stock beta is higher, there is more risk but also often the possibility for greater reward. If beta is negative, the stock generally moves in the opposite direction from the market as a whole.
A stock's 'Beta' is a measure of its volatility derived from the capital asset pricing model.
Understanding the Beta Definition
The term beta in finance, sometimes written using the Greek letter beta (β), is a measure of volatility in a particular stock or other investment opportunity. It comes from a mathematical formula known as the capital asset pricing model, which captures how stock prices evolve to take into account both overall market risk and reward, and the risk and reward involved in making particular investments.
Overall market risk is often gauged by looking at a broad market index, meaning one including a large number of stocks available for sale, such as the Standard & Poor's 500 Index or Russell 2000 Index. For other types of investments beyond stocks, a different benchmark index might be used, such as an index of bonds for bond investments.
A stock with a beta of greater than 1 is more volatile than the stock market as a whole, meaning investors can expect wider swings in price, potentially leading to bigger losses or gains. A stock with a beta value of exactly 1 is essentially as volatile as the market, while beta values greater than 0 and less than 1 indicate less volatility than the market.
Negative beta values with higher absolute value also represent more volatility, but the minus sign indicates that prices for the stock tend to swing in opposite directions from the market as a whole.
Investing With Beta
Stocks with high beta values are generally riskier, but that's not necessarily a bad thing. Investors often do well to mix riskier and less risky investments, diversifying their portfolios to see a decent return over time. Younger investors are often advised to take on some riskier investments compared to others who are approaching retirement and may not be able to take on the same level of risk.
Simply looking at a published or calculated beta number isn't generally enough to choose investments, of course. You'll want to understand the fundamentals of what a company does before you choose to invest in it, and you'll want to look at how it has performed comparable to other similar companies, what it has disclosed in its regulatory filings with the Securities and Exchange Commission and what it has announced about plans for the future.
Still, beta can be a useful metric in considering how risky and how rewarding a particular investment may be. You can calculate beta measures yourself using historic stock prices and a spreadsheet program such as Microsoft Excel, but you can also find them online through brokerage and stock market information sites.
Alpha and Beta
Another Greek letter that sometimes appears in stock market discussions is alpha, or α. This refers to the actual level of returns of a stock, fund or other investment relative to the market. Again, the S&P 500 is frequently used as a benchmark referring to the market as a whole.
Alpha is often expressed as a single number, measured in percentage points. For example, an alpha of 2 refers to a fund or stock performing 2 percent better than the S&P 500, while an alpha of -4 refers to it performing 4 percentage points worse than the S&P 500. A positive alpha doesn't necessarily mean an actual gain, nor does a negative alpha mean an actual loss, since the number is relative to the market as a whole.
Alpha is often used to compare and rank fund managers, although those that see high alpha numbers in one year may be taking risky positions that won't pay off in perpetuity.
Stocks with high beta are likely swing between high and low alpha, due to their inherent volatility. A stock with a beta of 1, meaning it perfectly tracks the market as a whole, would have an alpha of 0, since there's no variation from its results and the larger market.
Past Performance and Future Results
By definition, both alpha and beta are calculated based on an investment's prior performance, since that's all the data that is available about how investments perform relative to the market.
Since market conditions and economic fundamentals change, measured alpha and beta can't always predict how well an investment will perform in the future or how volatile a stock price will prove relative to the underlying market.
If a company is in a once sleepy but now fundamentally changing industry, perhaps affected by changing consumer tastes or new technologies, it may see sudden shifts in prices that would be unpredictable based on prior results. Companies that made camera film and typewriter ink ribbons, prior to the digital technology revolution that made such equipment into novelties rather than office necessities, are good examples.
Volatile Stocks and Scams
Some of the stocks most prone to volatility are small market capitalization stocks, meaning those with a small total value. They often trade at limited volume and have a limited number of shares outstanding, meaning a relatively few number of transactions can shift prices up or down. Many are also so-called penny stocks, meaning that individual shares are inexpensive, usually offered for $5 or less. They may be traded through the less-formal, over-the-counter system rather than on big exchanges like the New York Stock Exchange or Nasdaq, although you can still often buy and sell them through traditional and mainstream online brokers.
These stocks can be good for investors looking to get in on the ground floor of a new company, but they can also be an ideal market for scammers looking to manipulate stock prices to make money unscrupulously. Scammers will purchase penny stocks and then, without revealing their investments, promote the companies online, through phone calls or junk mail. Then, when other investors get interested in the company and begin to bid up the stock price, they'll dump their holdings, leaving other investors in the lurch as prices begin to come down.
Make sure you understand the fundamentals of stocks that you're considering investing in beyond factors such as rapid price gains or raw volatility numbers. Penny stocks often have high beta, because the small number of shares leads to rapid price shifts and volatility, but that's not necessarily good for investors. Study SEC filings, news reports and other information you can find about the company, and be skeptical of anyone promoting stock tips that seem too good to be true. The same applies to other types of investments, including precious metals and cryptocurrencies, which have all attracted fraudsters in the past.
Beta in Index Funds
If you're looking to capture the returns and risks of the market as a whole, you can do so by investing in index funds. These are funds that pool investor money to put into a basket of stocks that tracks a well-known market index, such as the S&P 500 or the Nasdaq Index. By definition, they will rise and fall with the index they are tracking, meaning alpha essentially 0 and beta essentially 1 compared to that index.
Index funds often charge smaller fees than actively managed funds, which employ human experts to pick stocks. They can be found through many brokerages, and some are exchange-traded funds, meaning they can be purchased through the stock market like stocks themselves. Compare index funds available through your favored financial institutions to find one with the prices you want offered by a company you trust.
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.