Beta Study
By Samantha Baltodano
TL;DR:
Beta is a measurement of market risk or volatility, indicating how much a stock's price fluctuates compared to other stocks. It is calculated as the ratio of covariance between the return on investment of a security and the market return to the variance of the market.
Beta values are interpreted as follows: 1.0 indicates the security moves with the market; a value greater than 1 means it is more volatile than the market; a value less than 1 means it is less volatile.
Beta is important in determining an investor's risk tolerance and preferences. Low beta assets are suited for risk-averse investors while higher beta stocks are suitable for those willing to take on more risk.
What Is The Beta Study?
In investing, beta does not refer to fraternities, product testing, or old videocassettes. Beta is a measurement of market risk or volatility. That is, it indicates how much the price of a stock tends to fluctuate up and down compared to other stocks.
The Beta coefficient measures the systematic risk of a security, sensitivity of security's returns to market returns. As the benchmark of this measurement, the market is defined as having a beta of 1.0.
What Is the Beta?
The value of any stock index, such as the Standard & Poor's 500 Index, moves up and down constantly. At the end of the trading day, we conclude that "the markets" were up or down.
An investor considering buying a particular stock may want to know whether that stock moves up and down just as sharply as the market in general. It may be inclined to hold its value on a bad day or get stuck in a rut when most stocks are rising.
The beta is the number that tells the investor how that stock acts compared to all other stocks, or at least in comparison to the stocks that comprise a relevant index.
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the overall stock market.
In other words, it gives a sense of the stock's risk compared to that of the greater market's. Beta is used also to compare a stock's market risk to that of other stocks.
Analyzing Beta
In the mathematical sense, Beta is the ratio of covariance between the ROC of the security and that of the market to the variance of the latter.
Don’t worry! You won’t be quizzed on the equation later, but it’s good to have a general idea of what’s happening under the hood here.
Beta values are interpreted as follows:
- A beta of 1 indicates that the security's price tends to move with the market.
- A beta greater than 1 indicates that the security's price tends to be more volatile than the market.
- A beta of less than 1 means it tends to be less volatile than the market.
Many young technology companies that trade on the Nasdaq stocks have a beta greater than 1. Many utility sector stocks have a beta of less than 1.
Essentially, beta expresses the trade-off between minimizing risk and maximizing return. Say a company has a beta of 2. This means it is two times as volatile as the overall market. We expect the market overall to go up by 10%. That means this stock could rise by 20%. On the other hand, if the market declines 6%, investors in that company can expect a loss of 12%.
If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: A market return of 10% would mean a 5% gain for the company.
Here is a basic guide to beta levels:
- Negative beta: A beta less than 0, which would indicate an inverse relation to the market, is possible but highly unlikely. Some investors argue that gold and gold stocks should have negative betas because they tend to do better when the stock market declines.
- Beta of 0: Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
- Beta between 0 and 1: Companies that are less volatile than the market have a beta of less than 1 but more than 0. Many utility companies fall in this range.
- Beta of 1: A beta of 1 means a stock mirrors the volatility of whatever index is used to represent the overall market. If a stock has a beta of 1, it will move in the same direction as the index, by about the same amount. An index fund that mirrors the S&P 500 will have a beta close to 1.
- Beta greater than 1: This denotes a volatility that is greater than the broad-based index. Many new technology companies have a beta higher than 1.
- Beta greater than 100: This is impossible, as it indicates volatility that is 100 times greater than the market. If a stock had a beta of 100, it would go to 0 on any decline in the stock market. If you see a beta of over 100 on a research site it is usually a statistical error or the stock has experienced a wild and probably fatal price swing. For the most part, stocks of established companies rarely have a beta higher than 4.
Why Beta Is Important
Are you prepared to take a loss on your investments?
Many people are not and they opt for investments with low volatility.
Others are willing to take on additional risk for the chance of increased rewards.
Every investor needs to have a good understanding of their own risk tolerance, and a knowledge of which investments match their risk preferences.
Investors who are very risk-averse should put their money into assets with low betas, such as utility stocks and Treasury bills.
Investors who are willing to take on more risk may want to invest in stocks with higher betas.
Test The Beta Study
Great news!
You can back test this exact strategy on historical data for any of your favorite symbols using TradingView.
This strategy has already been built and all you have to do is log in and take it for a spin. You can access this indicator here.
If you’re new to back testing and to TradingView, don’t worry. I created a step-by-step guide you can follow to begin testing the Beta Study.
Summary
- Beta indicates how volatile a stock's price is in comparison to the overall stock market.
- A beta greater than 1 indicates a stock's price swings more wildly (i.e., more volatile) than the overall market.
- A beta of less than 1 indicates that a stock's price is less volatile than the overall market.
- A beta of 1 indicates the stock moves identically to the overall market.
Beta is just one of many studies that Archaide automates. For a full list of strategies and studies available click here.
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