Beta
Most investors have heard of “Alpha,” which is the amount by which a stock outperforms. Less well known is the concept of “Beta”—a stock’s level of sensitivity to market volatility. Understanding any stock’s Beta, can help investors get a feel for how their portfolios are likely to respond in rising or falling markets. This information can aid investors in selecting a portfolio that aligns with their financial goals and risk tolerances.
Beta is the measurement of an asset’s relative volatility as compared to a benchmark, and the most common Beta benchmark is the S&P 500. This implies that the Beta of an investment indicates how sensitive its price movement is, compared to the price movement of a given benchmark. As the baseline measurement of volatility, the benchmark is represented by a Beta of 1.00. An investment with a Beta of 1.00 would, therefore, be expected to move up or down by the same percentage as the movement of the benchmark. A 1% gain in the benchmark would be matched by a 1% gain in the investment. An investment with a Beta of less than 1.00 would be expected to move up or down by less than the percentage movement of the associated benchmark. A Beta greater than 1.0 indicates more sensitivity to the benchmark.
What Does This Mean for Investors?
The different levels of sensitivity for various investments can be attributed to a number of aspects. A higher Beta stock may show increased sensitivity to the price movements of a benchmark due to the volatility of the company’s industry.
For example, biotechnology, is viewed as higher-growth industry with higher volatility, than the overall market. Thus, biotechnology stocks would tend to carry a higher Beta. An example of a lower Beta industry is utilities, where the variability of metrics, such as a company’s earnings, is less volatile. When selecting stocks for a portfolio, investors should do more than simply pick an investment based on its past performance at a particular point in time.
Beta is a useful tool for understanding the different return patterns of various stocks or asset classes, but it is not a metric to be used in isolation when making an investment decision. Generally, a conservative investor will want to invest in stocks with a lower Beta. They are sacrificing potential upside gains, in exchange for less volatile stock. Conversely, more aggressive investors may seek higher Beta stocks to capitalize on the upside of market volatility while risking a greater downside. Irrespective of risk tolerance, Beta is an excellent tool to evaluate the investments in any portfolio for volatility.
By Richard Ascher, Managing Director of Wealth Management Advisors