Why Investors Pay Attention to Beta
Beta can be used to understand the volatility of the stockswithin your portfolio so you can stay consistent and understand the risk youare really taking. Beta can be used to make sure you aren’t taking on more orless risk than you had originally planned. It can also help you understand whyyour total portfolio may be reacting disproportionately to the price movementof just one or two stocks or why it is lagging/leading the major market indexes. [Learn to compare two stocks withdifferent betas. | “Beta” CEE article]
How it Works
Beta measures the level of correlation between a stock andthe S&P 500 stock index. It is sometimes considered a measure of risk andtraders 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 aone-for-one percentage-point basis with the S&P 500. If a stock has a betagreater than 1.0 then it is expected to move up or down more than the S&P500 and a stock with a beta below 1.0 should move less. [Compare a stock you are watching with theS&P 500. | “Beta” CEE article]
- [Analyzethe beta of the stocks you own | “Beta” CEE article]
- [Findhigh beta stocks | “How to Search for Good Stocks” IDV article]
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For example, if a stock in your portfolio has a beta of 2.0and the S&P 500 moved down by 1% on a given day then the stock should bedown 2%. If you have a stock with a beta of .8, then it should be up .8% on aday that the S&P 500 moved up by 1%. If these two stocks were your onlyholdings, which stock is going to dictate the overall movement of the totalportfolio? This may be an issue for traders with a portfolio split between veryhigh-beta stocks and low beta stocks, who may not realize that the high-betaholdings are going to have the greatest influence on the total value of theportfolio.
You can find the beta for a stock on the summary quote pageon Yahoo! Finance. At the time thefollowing 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 thatthe S&P 500 has moved in a given day. If the S&P 500 closed up by .5%then GE should be up by .74%. In other words, if its stock price was currently$25 then it should have risen about $.19 per share to $25.19 on a day theS&P 500 moved .5%.
Take a minute to compare two stocks in your portfolio that you think shouldhave a beta close to 1 and see if you were correct. If you don’t have anycompanies 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 orrisky than the S&P 500 itself. Thinkabout how that may make an investing decision between DUK and T easierdepending on your risk tolerance and objectives. You should also consider how astock with a very high beta will affect the returns from the stocks already inyour portfolio.
It is also possible to have a negative beta, which meansthat the stock is expected to move inversely to the S&P 500. If a stock hada beta of -1.0 you would expect it to move up by 1% if the S&P 500 droppedby -1%. At first glance it may sound attractive to add a few stocks withnegative betas to a portfolio so that you will perform better when the stockmarket moves down. However, reality is a little more complicated than that.
Beta is a statistical study of past prices and it can befooled by erratic movements in a stock. Its possible for very volatile stocksto have a low beta just because they have a very low level of correlation withthe 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 comparethe relative volatility of two similar stocks in your portfolio. Traders whoare making a decision about investing in a specific industry group may use betato help them understand how volatile their investment candidates will be in thefuture. That will help them find a stock that is a better match for their risktolerance and investing objectives.
Pull up the summary quote page for two utility companies; Duke Energy (DUK) andConsolidated Edison (ED) and write down their beta. Don’t worry too much abouthow 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 relativevolatility between the two stocks. At the time of this writing (see the nextimage) ED had a lower beta and should be expected to be less volatile than DUKin the future.
These two utilities stocks have low betas that are very differentwhen compared to each other. From this information you would assume that DUK isgoing to outperform ED in a bull market but may lose more in a bearish one. Inthe next chart you can how DUK (Blue) and ED (Red) performed relative to eachother over the 6 months prior to this article. The period covered is a bullmarket and DUK outperformed significantly as you would have expected based onbeta alone. [Learn to create achart comparison like this yourself. | “Stock Charting Basics” IDV article]
Use beta to get a deeper understanding for how a stock inyour portfolio is expected to affect its total value. High beta stocks mayoffer larger upside when things go your way, but because they are riskier, theymay overwhelm other winning positions in your portfolio with a lower beta. Sometraders will deal with this by holding fewer high-beta than low-beta stocks sothat the extra volatility doesn’t overwhelm their total portfolio.
You can also use beta to compare stocks that are closely relatedbefore adding them to your portfolio. Whether you prefer the high-beta orlow-beta stock in that comparison will depend on your risk tolerance and theneeds of your portfolio. If you want to ramp up the potential for reward thenthe high-beta alternative may be the right choice. But if you are trying tocool things off in a portfolio with an average beta that is a little higherthan you are comfortable with, then the low-beta stock may be the optimaldecision.