Investing Education: Beta

Learning Markets

Why Investors Pay Attention to Beta

Beta can be used to understand the volatility of the stocks within your portfolio. Understanding volatility is important so you can help your portfolio maintain consistent returns and you can better understand the risks you may be taking at any one time. Beta can be used to make sure you aren’t taking on more or less risk than you had originally planned. It can also help you understand why your total portfolio may be reacting disproportionately to the price movement of just one or two stocks; or, why it is lagging or leading the major market indexes

How it Works

Beta measures the level of correlation between a stock and the S&P 500 stock index. It is sometimes considered a measure of risk and traders can use it to compare similar stocks within an industry group or sector. If a stock has a beta of 1.0 that means that it will move up or down on a one-for-one percentage-point basis with the S&P 500. If a stock has a beta greater than 1.0 then it is expected to move up or down more than the S&P 500 and a stock with a beta below 1.0 should move less

For example, if a stock in your portfolio has a beta of 2.0 and the S&P 500 moved down by 1% on a given day then that stock should be down about 2%. If you have a stock with a beta of 0.8, then it should be up about 0.8% on a day that the S&P 500 moved up by 1%. If these two stocks were your only holdings, which stock is going to dictate the overall movement of the total portfolio? This may be an issue for traders with a portfolio split between very high-beta stocks and low beta stocks, who may not realize that the high-beta holdings are going to have the greatest influence on the total value of the portfolio.

You can find the beta for a stock on the summary quote page on Yahoo! Finance. At the time the following image was taken General Electric Company (GE) had a beta of 1.47 which means that, on average, GE should be up or down 147% of the amount that the S&P 500 has moved in a given day. If the S&P 500 closed up by 0.5% then GE should be up by 0.74%. In other words, if its stock price was currently $25 then it should have risen about $0.19 per share to $25.19 on a day the S&P 500 moved up 5%.

 

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Practice:

Take a minute to compare two stocks in your portfolio that you think should have a beta close to 1 and see if you were correct. If you don’t have any companies in mind then go to the summary page for AT&T (T) and Duke Energy (DUK). Normally, T has a beta very close to 1.0 while DUK has a very low beta. DUK is a utility stock and that industry tends to be much less volatile or risky than the S&P 500 itself. Think about how that may make an investing decision between DUK and T easier depending on your risk tolerance and objectives. You should also consider how a stock with a very high beta will affect the returns you receive from the stocks already in your portfolio.

It is also possible to have a negative beta, which means that the stock is expected to move inversely to the S&P 500. If a stock had a beta of -1.0 you would expect it to move up by 1% if the S&P 500 dropped by -1%. At first glance it may sound attractive to add a few stocks with negative betas to a portfolio so that you will perform better when the stock market moves down. However, the reality is a little more complicated.

Beta is a statistical study of past prices and it can be fooled by erratic movements in a stock. It’s possible for very volatile stocks to have a low beta just because they have a very low level of correlation with the S&P 500.

If beta can be tricked so easily, is it still useful? Yes. Like many other fundamental or technical metrics, beta can be used to compare the relative volatility of two similar stocks in your portfolio. Traders who are making a decision about investing in a specific industry group may use beta to help them understand how volatile their investment candidates will be in the future. That will help them find a stock that is a better match for their risk tolerance and investing objectives.

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Practice:

Pull up the summary quote page for two utility companies; Duke Energy (DUK) and Consolidated Edison (ED) and write down their beta. Don’t worry too much about how this relates to the S&P 500 since that can be a little misleading. Instead think about what the beta difference tells you about the relative volatility between the two stocks. At the time of this writing (see the next image) ED had a lower beta and should be expected to be less volatile than DUK in the future.

These two utilities stocks have low betas that are very different when compared to each other. Based on this information you would assume that DUK is going to outperform ED in a bull market but may lose more in a bearish one. In the next chart you can how DUK (Blue) and ED (Red) performed relative to each other over the 6 months prior to this article. The period covered is a bull market and DUK outperformed significantly as you would have expected based on beta alone. 

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Summary

Use beta to get a deeper understanding for how a stock in your portfolio is expected to affect its total value. High beta stocks may offer larger upside when things go your way, but because they are riskier, they may overwhelm other winning positions in your portfolio with a lower beta. Some traders will deal with this by holding fewer high-beta than low-beta stocks so that the extra volatility doesn’t overwhelm their total portfolio.

You can also use beta to compare stocks that are closely related before adding them to your portfolio. Whether you prefer the high-beta or low-beta stock in that comparison will depend on your risk tolerance and the needs of your portfolio. If you want to ramp up the potential for reward then the high-beta alternative may be the right choice. But if you are trying to cool things off in a portfolio with an average beta that is a little higher than you are comfortable with, then the low-beta stock may be the optimal decision.

 

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