What Beta Means When Considering a Stock's Risk (2024)

How Is Beta Calculated?

Beta is calculated usingregressionanalysis. Numerically, it represents the tendency for a security's returns to respond to swingsin the market.

To calculate the beta of a security, thecovariancebetween the return of the security and the return of the market must be known as well as thevarianceof the market returns. The covariance of the return of an asset with the return of thebenchmark is divided by the variance of the return of the benchmark over a certain period.

$\text{Beta} = \frac{\text{Covariance}}{\text{Variance}}$Beta=VarianceCovariance​

High Beta vs Low Beta: Which Is Better?

The higher the risk, the higher the potential reward is a common belief in investment circles. High-beta stocks are supposed to be riskier but provide higher return potential. Conversely, low-betastocks pose less risk but also offer lower potential returns. Which is best depends on what type of investor you are.

More conservative investors or those that wish to soon tap into their funds will likely prefer low-beta stocks. These kinds of stocks historically tend to not fluctuate much in value. They are companies that consistently deliver steady revenues and profits in times of economic expansion and hardship. Positive or negative surprises are lacking and valuations are based on very realistic expectations that the company has a history of reaching.

Investors keen to bag big capital gains or day traders looking to make a quick buck from fluctuating share prices would be more interested in high-beta stocks. The share prices of these companies historically have a tendency to jump around quite a bit. Racy stocks, such as tech upstarts with the potential to revolutionize how certain things are done, fall into this category. Investing in one could make you a fortune or lead to big losses. Their future is unpredictable and that leads to lots of speculation and price movements.

Higher beta stocks also tend to outperform in bull markets when the economy is in expansion mode and confidence is high, whereas lower beta stocks tend to fare better during recessions.

Low Beta Stock Example

Low beta stocks tend to be defensive companies. There is a constant demand for their products or services, regardless of where we are in the economic cycle, resulting in steady profits and revenues, which often translate into a steady share price and dividend payments.

A classic example of a low beta stock would be a company like Proctor & Gamble. The maker of household brands such as Pampers, Oral, Pantene, and Gillette, as of June 2024 has a five-year beta of 0.42. In other words, its share price fluctuates much less than the broader market. For every 1% move in the market, Proctor & Gamble's shares moved 0.42% on average. That's good in terms of protecting against losses but also means limited upside potential compared to other options.

High Beta Stock Example

High beta is generally associated with small companies or growth stocks. These are companies that are expected to grow revenues and profit fast and, as a result, experience lots of capital appreciation .

Many of the highest beta stocks are tech companies. A company behind the next big thing typically commands a high valuation. Investors buy the stock based on it living up to its potential, which requires lots of uncertain factors going its way. High hopes create volatility. A slip-up could result in the share price tumbling dramatically. Likewise, a small hint of good news can lead to another big rally.

Tesla falls into this category. There is a lot of hope baked into its share price, resulting in wild swings whenever it fails/exceeds expectations and a five-year beta of 2.41, as of June 2024.

Advantages of Using Beta as a Proxy for Risk

To followers of CAPM, beta is useful. A stock's price variability is important to consider when assessing risk. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.

Besides, beta offers a clear, quantifiable measure that iseasy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured. But broadly speaking, the notion of beta is fairly straightforward. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method.

Disadvantages of Using Beta as a Proxy for Risk

The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn't distinguish between upside and downside price movements. For most investors, downside movements are a risk, while upside ones mean opportunity. Beta doesn't help investors tell the difference. For most investors, that doesn't make much sense.

Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is riskier than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value—investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Beta says nothing about the price paid for the stock in relation to fundamental factors like changes in company leadership, new product discoveries, or future cash flows.

Beta doesn't pay attention to a stock's fundamentals or incorporate new information. Consider a utility company: let's call it Company X. Company X has been considered a defensive stock with a low beta. When it entered the merchant energy business and assumed more debt, X's historic beta no longer captured the substantial risks the company took on.

At the same time, many technology stocks are relatively new to the market and thus have insufficient price history to establish a reliable beta.

Another troubling factor is that past price movement is a poor predictor of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead. Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. However, for investors with long-term horizons, it's less useful.

The Bottom Line

Beta is the volatility of a security or portfolio against its benchmark. It's a numerical value that signifies how much a stock price jumps around. The higher the value, the more the company tends to fluctuate in value.

Ultimately, it's important for investors to make the distinction between short-term risk—where beta and price volatility are useful—and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities.