People who are interested in stocks will have seen the term “beta” being used here and there. Unfortunately, said term doesn’t provide much context for interested individuals to figure out what it might mean. Even worse, beta is so common that most people using it don’t feel the need to explain it, thus leaving interested individuals even more confused.
For those who are curious, the beta is a measurement of an investment’s volatility under certain circumstances. The beta is but a single measurement, meaning that interested individuals shouldn’t base their evaluation of an investment based on it and nothing else. Something that can be said for all the other measurements that can be found out there. Regardless, the beta says a lot of useful things about a stock, so let’s unpack it in more detail.
What is Beta
The beta (β) of an investment portfolio or security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market and is a common measure of risk.
High β – A security with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of the market return in each period.
Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in each period.
Negative β – A company with a negative β is negatively correlated to the returns of the market. For an example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%.
Why it matters
Beta can help investors choose investments that match their specific risk preferences. A risk-averse investor, for example, may want to avoid over-weighting their portfolio with high-beta stocks to avoid excessive volatility.
Beta is extremely important when putting together a portfolio of assets. A diversified portfolio consisting of assets with different betas, lowers the overall risk of the portfolio.
Alpha vs. Beta
“Alpha” is another common term you’ll see when researching investments, particularly active funds. Unlike beta, which simply measures volatility, alpha measures a portfolio manager’s ability to outperform a market index. Alpha is a measure of the difference between a portfolio’s actual returns and its expected performance, given its level of risk as measured by beta.
For example, if an active fund returned 10% in a year in which the market rose only 5%, that fund would have a higher alpha. Conversely, if the fund gained 10% in a year when the market rose 15%, it would earn a lower alpha. The baseline measure for alpha is zero, which would indicate an investment performed exactly in line with its benchmark index.
Generally, if you were investing in an active fund or other type of managed investment product, you would seek out managers with a higher alpha. Keep in mind that both alpha and beta are based on historical data. As every investment prospectus warns, past performance is no guarantee of future results.
The Beta Investor
Beta investors are usually passive investors. They are not looking to outperform the markets. They prefer to take the, “If you can’t beat them, join them,” approach to investing. They will accept returns that simply match the index of their choice because they expect that markets will rise throughout their investing lifetime, as they have historically.
That begs the question: what if those historical trends don’t hold true? What if markets take a dip, especially within a few years of retirement? One of the problems with matching the index is that you’re going to have periods of negative returns. You can lose money over lengthy periods of time, this is a reality of the market.
Beta investors would simply remind us that we need to reduce our investment risk tolerance as we age so that we’re not heavily invested in stocks during the 5 years before we retire (i.e. personal investment portfolio asset allocation). They would also caution that, for this strategy to work, you need to be able to sit tight through the downturns. If you sell during those draw-down periods, you’re likely to end up with negative returns. To match the index, you must stay with it.
Obviously, it is vital to have a general feeling for how the overall market is doing, since that is the basis for comparison with beta. If the market is trending upward with strong earnings estimate revisions, then it may behoove you to buy stocks with higher betas, as they would outperform. Conversely, avoid higher beta stocks in a weak market with decreasing estimate revisions. Beta is a powerful and often over-looked tool for investors.
The takeaway is every investor should understand the terminology used for their own investments. If you buy individual stocks, consider Beta. If you work with an active portfolio manager, ensure that you know what her/his Alpha is.