Beta measures how volatile a stock is in relation to the broader stock market over time. A stock with a high beta indicates it’s more volatile than the overall market and can react with dramatic share-price changes amid market swings. So if you don’t have the stomach for vast price changes, you may want to avoid investing in high-beta stocks. But beta is just one factor to consider when examining investments. We’ll review what beta means and how you can use it to build a better portfolio that matches your risk tolerance. A financial advisor can also help you take advantage of beta to make better investment decisions.

What Is Beta?

Investors often calculate beta by comparing a stock’s price changes to the movements of a benchmark index, such as the S&P 500, throughout a 12-month period. We’ll discuss calculating beta yourself in a bit. But first let’s understand why it matters, since you can use plenty of free online tools and calculators to compute it yourself.

Beta is represented as a number. Based on beta analysis, the overall stock market has a beta of 1. And the beta of individual stocks determines how far they deviate from the broader market.

How Beta Works

A stock with a beta equal to 1 assumes its price moves hand-in-hand with the market. Adding it to your portfolio may not add much risk.

A stock with a beta greater than 1 may indicate that it’s more volatile than the market. However, this could also mean it has the potential for stronger returns. Say your benchmark, or the market to which you’re comparing a stock, is the S&P 500. If the stock you’re analyzing has a beta of 2, that means the stock is twice as volatile as the market. If the S&P 500 goes up by 10% next year, you can expect the stock price to go up by 20%. However, it could plummet by just as much if the S&P 500 goes down by 10%.

If the stock has a beta less than 1, you can conclude that it’s less volatile than the overall market. This means that adding it to your portfolio may mitigate risk and may help in diversifying your investments.

Betas can also dip below 1 into negative territory. This indicates that the stock may respond in the opposite direction of the overall market. Using the previous example, you could expect the stock’s price to go up if the S&P 500 goes down and vice versa.

A stock can even have a beta of zero. This suggests that it acts independently of the overall stock market.

Pros and Cons of Using Beta

Understanding beta can be a valuable tool when building your investment portfolio. For those with a low risk tolerance, focusing on stocks with betas between 0 and 1 may align better with your financial goals. These stocks tend to be less volatile than the broader market, which can offer more stability.

For instance, you might want to steer clear of high-beta stocks, such as those from tech companies, that frequently experience larger swings than the market. A high beta signals greater volatility — and potentially greater risk.

However, in the world of investing, things are rarely black and white. Beta is based on historical data, and past performance doesn’t guarantee future outcomes. This means beta alone doesn’t give insight into a company’s fundamentals or its potential for future risks.

Consider a company historically seen as stable, with a low beta. If that company ventures into a new sector and takes on significant debt, its increased risk won’t immediately reflect in its beta due to the reliance on historical data.

That said, beta can still be a valuable metric, especially for investors who actively buy and sell stocks. It helps quantify market risk and provides a snapshot of a stock’s volatility compared to the broader market. The following are some of the pros and cons you might want to consider when it comes to using beta:

Pros of Beta:
- Helps gauge a stock’s volatility relative to the market.
- Useful for comparing potential risk between different stocks.
- Valuable for short-term or active traders assessing market trends.
Cons of Beta:
- Relies on historical data, which may not reflect future performance.
- Ignores company-specific fundamentals, such as financial health or growth potential.
- May underestimate risk in companies undergoing significant changes or restructuring.

Ultimately, beta is just one of many tools investors should use when evaluating investments. Calculating a stock’s beta can be a good starting point, but it’s important to complement it with a thorough analysis of the company’s fundamentals and broader market trends.

Before You Calculate Beta

Remember, beta measures how volatile a stock’s price may be in relation to a market benchmark. To get the most out of a good beta calculation, that benchmark must be as related to the stock as possible.

So if you’re examining the stock of a a large U.S. company, a good choice would be the S&P 500. This market index covers the 500 U.S. companies with the largest market capitalization. But if you’re looking at the stock of a company that’s more active overseas, you may want to use an international market index instead.

Again, keep in mind that beta relies on past performance. Decide on a particular time frame to examine. If you’re investing for the long term, you may want to factor in a time frame of about five to 10 years. If you’re a trader who buys and sells on a regular basis, consider using a few days or weeks.

Generating your quiz…

How to Calculate Beta

Now that you have that set, let’s begin crunching some numbers. To begin, gather the following:

Stock’s closing price for each day in your desired time frame
Daily closing level of your chosen benchmark index during the same time period
Spreadsheet software to run the numbers

Open the spreadsheet. In the first column, insert the dates for the range you selected. In the second column, enter the closing prices for the stock you’re considering. And in the third column, insert the closing prices for the index you’re using.

The next step is to compute percent daily price changes for the stock and the index. For each entry, subtract that day’s cost price from that of the previous day. Divide the result by the price of the previous day. Multiply by 100. The result is the percentage. That would update your spreadsheet.

Now, use a covariance formula to compare how the stock’s and index’s prices move in relation to each other. Divide this covariance result by the variance of only the index. This allows you to see how the stock and index prices moved in relation to one another, relative to how the index price moved on its own. Therefore, you get beta.

Beta = (Stock’s % daily change and Index’s % daily change) / (Index’s % daily change.)

Bottom Line

Beta can be a useful metric to determine how a stock’s price may move in relation to the overall market by examining its past performance. It can also be a useful indicator of risk, especially for investors who make trades frequently. However, beta has its limitations. It doesn’t account for how companies may undergo major changes in the future, for example. It also relies solely on past metrics. Still, it serves as one of many useful factors you can weigh when making investment decisions.

Tips on Making Better Investment Decisions

Understanding beta and everything else involved with picking the right stocks can be a difficult process. This is why the guidance of a financial advisor can come in handy when making investing decisions. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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