Beta (finance) - Investing

Investing

By definition, the market itself has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the macro market (for simplicity purposes, the S&P 500 is sometimes used as a proxy for the market as a whole). A stock whose returns vary more than the market's returns over time can have a beta whose absolute value is greater than 1.0 (whether it is, in fact, greater than 0 will depend on the correlation of the stock's returns and the market's returns). A stock whose returns vary less than the market's returns has a beta with an absolute value less than 1.0.

A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market's returns; when the market's return falls or rises by 3%, the stock's return will fall or rise (respectively) by 6% on average. (However, because beta also depends on the correlation of returns, there can be considerable variance about that average; the higher the correlation, the less variance; the lower the correlation, the higher the variance.) Beta can also be negative, meaning the stock's returns tend to move in the opposite direction of the market's returns. A stock with a beta of -3 would see its return decline 9% (on average) when the market's return goes up 3%, and would see its return climb 9% (on average) if the market's return falls by 3%.

Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. Some have challenged this idea, claiming that the data show little relation between beta and potential reward, or even that lower-beta stocks are both less risky and more profitable (contradicting CAPM). In the same way a stock's beta shows its relation to market shifts, it is also an indicator for required returns on investment (ROI). Given a risk-free rate of 2%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.5 should return 11% (= 2% + 1.5(8% - 2%)).