What is beta in investing?

What is beta in investing?

Beta is a volatility indicator that denotes how closely an investment follows movements in the market as a whole; when examining mutual funds, it indicates how similarly the funds move to their relevant indexes. It is often referenced with its counterpart, Alpha; a risk ratio which measures gains or losses relative to a benchmark, indicating whether an investor is being compensated with a return greater than the volatility risk being taken.

By examining the systematic risk of a security or a portfolio in comparison to the entirety of a market, investors can enhance their decision-making in anticipation of volatility. Volatility, or the measure of the variance, deviation, or movement of a stock, is the extra movement of a stock or other security over and above (and below) a line of averages.

While some definitions of beta will imply that it is a measure of volatility, it is at its core a correlative measurement that compares the times when a security experiences price movement and when the market as a whole (or the S&P 500) experiences price movement. Beta measures how many changes in price, and by how much, a security experiences over an amount of time.

Beta is calculated using covariance and variance of an asset: these factors combine to paint a picture of the tendency of an investment’s return to respond to swings in the market. If the security and the market move by similar amounts at the exact same time, the investment will have a Beta of 1.0, which is a strong correlation to the market as a whole – it will essentially move in conjunction with the market.

Individual security and portfolio values are measured according to deviation from the market. Betas below 1.0 imply lower correlation with (or less volatility than) the market, and Betas above 1.0 imply exaggerated movement at similar times (or greater volatility relative) to the rest of the market. In each case, standard deviations between the two (the security and the index) are compared at specific times to arrive at the number. If a stock has a Beta of 1.21, it is 21% more volatile than the market.

Understanding risk is vital to understanding the Beta figure. In finance, it is common to hear about the correlation between risk and return. Risk can be defined as exposure to the possibility of loss of an asset; it might be used to denote the cause of the potential loss, or the probability of the loss.

More risk may yield a higher return, but it also has the potential for more loss. The situation requires that an investor willing to take such a risk must provide the capital to fund the investment which may grow or may fail.

If the security experiences movements in opposition to the market as a whole, it can have a negative Beta. Gold has plenty of price volatility, for example, but moves in ways that are not highly correlated with the rest of the market – as a result, it has a Beta of less than 1. This can serve as a hedge – a way for investors to protect themselves from disastrous losses by strategically insulating themselves from unfavorable price movements – or as an ​ ”alternative" investment for increased diversification.

Investors should be aware of the theory of Beta Decay, which says if a company stock starts out in early years with a Beta greater than 1, that its beta will gradually experience regression toward the mean and will become more closely correlated with the market over time. This lockstep movement illustrates the kind of stability that is favored by more conservative investors.

The Beta coefficient is intrinsic to the capital asset pricing model (CAPM) and the Efficient Frontier – each financial theory uses Beta measurements to assess the suitability and expected return of securities in a portfolio and help manage risk.

Ultimately, more conservative investors looking to maintain capital will focus on securities with low betas, while investors with an appetite for more risk will be comfortable with high-beta investments.