The average investor may not be familiar with what beta means, but they are no doubt fully aware of what it represents. Although there are different types of risk in the market, a stock’s beta represents perhaps the most important risk for many investors: its volatility. After all, most investors would prefer a stock that returns a steady, consistent 10% rather than one that returns the same 10% but only after falling 50% and then skyrocketing by over 100%. Although beta isn’t a predictive measure of return, it does intend to convey the ups and downs that an individual stock will exhibit on average against the market as a whole.
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So, how exactly is beta calculated, and what number is considered a low beta? Read on to learn the basics of what you should know before you start investing.
Does Beta Measure Risk?
Technically speaking, beta doesn’t measure risk. It’s simply a statistical measure of correlation between a stock and the overall market. For example, if a stock tends to show varying returns that are 50% greater than the movements of the overall market, that stock will have a beta of 1.5. The overall market has a beta of 1.0, as it is the benchmark by which the varying returns of individual stocks are measured. So, a stock that is 20% less volatile than the overall market will have a beta of 0.8.
While beta doesn’t measure the risk of a stock per se, it does attempt to filter out how much of the variation of a stock’s return is caused by the stock itself as opposed to the market as a whole. For this reason, beta is said to measure a stock’s “non-systematic” risk, as opposed to the “systematic” risk that every stock has just by virtue of being part of the overall market.
While an investor can’t do anything to reduce the beta of an individual stock, he or she can limit the non-systematic risk of a portfolio by adding additional stocks to it. The more stocks an investor adds to a portfolio, the more the risk characteristics of the portfolio will approximate the market as a whole. While there is such a thing as overdiversification, a diversified portfolio is a proven way to reduce the non-systematic risk brought to the table by each individual stock.
What Is a Good Beta for a Stock?
There is no such thing as an empirically “good” or “bad” beta for a stock. The type of beta you want for your portfolio depends on the type of investor you are. If you’re building a high-dividend, low-volatility portfolio that’s of a more conservative nature, a low beta — below 1.0 — is likely a good choice for you. But if you’re looking for maximum capital appreciation potential and can handle violent swings in the price of a stock, you’ll likely seek out high-beta stocks instead. What’s a “good beta” for a stock is one that helps you achieve your investment objectives while staying within your risk tolerance.
What Are the Betas of Some Well-Known Stocks?
Generally speaking, high-growth technology stocks tend to have high betas. Advanced Micro Devices and NVIDIA, for example, are both chip makers and both have betas above 2, at 2.09 and 2.31, respectively. Tesla and Netflix aren’t far behind, at 2.17 and 2.16, respectively, while Apple and Amazon come in just below 2, at 1.96 and 1.93. Investments in these types of stocks can be hard for those with low risk tolerances, but the long-term rewards — and sometimes, the short-term rewards as well — are worth it for many investors. More conservative stocks like AT&T and Pfizer, for example, have betas of just 0.44 and 0.37, respectively.
How Can an Investor Take Advantage of a High Beta?
If an investor seeking capital gains thinks the overall market is on an upswing, he or she may purposely seek out the highest-beta stocks available. As long as those stocks remain within an investor’s risk tolerance, they may provide for outsized gains simply due to the way they trade. For example, if the market is making a big move 20% higher, a stock with a beta of 1.5 will tend to trade up 30%. In this way, an investor can maximize gains in a bullish market by picking up shares of volatile stocks. Of course, no correlation is this black and white, and it’s entirely possible that bad corporate news can drive any stock down, even during a market upswing. It’s also true that a stock with a beta of 1.5 may very well trade down 30% if the market sells off by 20%, so investing in this manner is not without its risks.
Does Beta Encapsulate All of a Stock’s Risk?
Beta is an important measure of one type of risk, but it doesn’t encapsulate all of a stock’s risk. Stocks are shares of real-life businesses, which subjects them to the economic fortunes of their underlying companies. Regardless of a stock’s beta, or the overall direction of the market, if a company has financial difficulties, its stock will suffer. Companies also face many other types of risks, from the risk of bad publicity, adverse legislation or changing consumer behaviors, among others. Beta is simply one measure of the risk of how a stock trades.
The Bottom Line
A stock’s beta doesn’t tell investors exactly how it is going to trade, but it is a good gauge of how volatile it will be against various market backdrops. Investors looking to leverage their trading can pick up shares of high-beta stocks during bull markets to improve their chances for outsized gains, but they’re also risking losing more money if the market as a whole trades down. This is why determining both your investment objectives and risk tolerance, preferably with the help of a financial advisor, is important before you decide which stocks you want to own.
Information is accurate as of Sept. 30, 2022.
This article originally appeared on GOBankingRates.com: What Beta Means: Understanding a Stock’s Risk
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
