Beta is another measure of volatility that gives an investor an idea of how risky a stock is likely to be. It is used to compare the risk of a particular stock against the risk of the whole market (i.e. a market index). Luckily, beta is quite an easy concept to understand.
As a standard, the market as a whole has a beta that is equal to 1. It represents the level of volatility that an investor would be exposed to, if they just invested into a market index fund. Unlike the market, stocks can have a beta that is either higher than 1, less than 1, or equal to 1. If an investment has a beta of 1, it means that it has the same level of risk as the market – therefore, if the market increase, the stock will increase by a very similar amount.
If a stock has a beta that is higher than 1, it means that it is more volatile than the market. For example, if a stock has a beta of 1.5, then it means that when the market increases by 10%, the stock should increase by around 15%. Equally, if a stock has a beta that is less than 1, it makes it less volatile than the market. For instance, a beta of 0.5, then it means that when the market increases by around 10%, the stock would increase by around 5%.
Thankfully, there is no need to know how to calculate beta as it is easy to find. If you look for a stock on a website like Google or Yahoo Finance, the beta of the stock will be given.
On rare occasions, it can be the case that the beta of a stock is negative. This simply means that the stocks moves in the opposite direction to the market as a whole. In the extreme case, if a stock had a beta of -1, it would mean that the stock moves in exactly the opposite direction to the market.
Negative betas are sometimes useful as it allows an investors to diversify their portfolio and offset losses when their other stocks decline. For example, if an investor held a stock with a beta of -0.5, as well as a market index fund, when the market decreased by 10%, the stock with the negative beta would increase by around 5%. Therefore, the net position of the investor would be -5%, instead of -10%.
Stocks with a negative beta are uncommon and tend to be more visible in industries like gold mining.
This is especially likely to happen with gold, as investors buy gold when inflation is high. So, when the rest of the market declines due to high inflation, gold-related stocks will likely increase in value.
Although beta has the advantage of being an easy way to assess the volatility of a stock, it has drawbacks. As we have discussed with other methods, as beta uses historical data, it is limited in how useful it is in terms of explaining the future performance of a stock. In fact, beta can change dramatically over time.
In addition, beta is arguably not so useful in determining the long term volatility of a stock. This is the case because other factors play a role in terms of the long term stability of a stock, such as the development stage that the company is in.
For those reasons, beta should be used in combination with other methods of analysis.
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