There's so many metrics one can look at when evaluating a stock. But don't you wish there was a metric that could show you how volatile a stock is? Beta is a metric that sort of works like that, but it's a bit more complicated. Let's take a look.
Beta is a numerical value that represents the sensitivity of a stock's price movements relative to the broader market, typically represented by a big index like the S&P 500. The market itself is assigned a beta of 1.0.
Different beta values mean different things to investors, so here is a guide on the beta value ranges and what they typically mean:
Beta = 1.0: A stock with a beta of 1.0 moves in line with the market. If the market goes up by 5%, the stock is also expected to rise by 5%, and vice versa.
Beta > 1.0: A stock with a beta greater than 1.0 is more volatile than the market. For example, a beta of 1.5 suggests that the stock is 50% more volatile than the market. If the market increases by 5%, the stock might rise by 7.5%, but if the market falls by 5%,
the stock might drop by 7.5%.
Beta < 1.0: A stock with a beta less than 1.0 is less volatile than the market. A beta of 0.5 indicates that the stock is only half as volatile as the market. In this case, a 5% market increase would lead to a 2.5% rise in the stock, and a 5% market drop would lead to a 2.5% decline in the stock.
Negative Beta: Occasionally, a stock may have a negative beta, meaning it moves inversely to the market. A negative beta stock could rise when the market falls, and vice versa.
But why exactly does beta matter? I have three good reasons for you.
First, having less volatile stocks means less risk in your portfolio. If an investor is trying to minimize risk in their portfolio, they should invest into stocks with beta numbers that are less than 1 but greater than 0. Furthermore, aggressive investors may seek high-beta stocks in order to maximize their potential profits. Although it is far riskier, growth investors may look at more volatile stocks, say Tesla for example (2.31 Beta!), and invest into them to maximize potential profits. Last but not least, by understanding the beta of individual stocks, investors can balance their portfolios with a mix of low and high-beta assets, further diversifying their portfolios with different kinds of volatility-leveled stocks.
But what are the limitations of the beta metric?
Although there its a useful metric to use when picking your stocks, there are still some shortcomings to the beta value. For example, beta is calculated based on historical data, which may not always predict future performance accurately, especially in rapidly changing markets. Beta also assumes the relationship between a stock and the market is constant, which might not hold true in all market conditions. Further, the beta metric does not account for company-specific factors that might affect a stock's performance, such as changes in management, new product launches, or regulatory issues. These issues may lead investors to overlook the beta values at times regarding their picked stocks.
In conclusion, the beta metric is a useful tool when it comes to evaluating your stocks. If you want to see just how volatile a stock is compared to the market itself, do yourself a favor and look at the beta value on your desired stock picks. And although beta is an important metric, it does have its limitations at time, so proceed with caution. Keep educating yourself and stay learning!
