Beta is a measure of the market risk or volatility of investing in a stock. It helps investors pick stocks that fall into their risk comfort zone.
But what does it tell you about a stock and what mixed signals do investors get when three different Web sites report three different betas for the same stock?
Why can three Web sites give three different answers to the same question about a stock’s beta and one answer was much different from the other two?
- The market risk of investing in a stock can be measured using a beta score, which can help determine how likely it is that the price will change drastically in the short term.
- While it can be calculated several ways, Beta isn't as helpful when looking at long term volatility.
- If you are going to use beta scores in your investing, use scores from the same source so you can be assured the data collection and analysis are consistent.
What Is Beta?
Beta is a score that measures a stock’s volatility or risk against the rest of the market. It can be calculated several ways, including using regression analysis.
The market, which is usually the S&P 500 Index, is given a beta of 1. If the stock is more volatile than the market, its beta will be more than 1, and if it is less volatile than the market, its beta will be less than 1.
For example, a stock with a beta of 0.8 would be expected to return 80% as much as the overall market. A stock with a beta of 1.2 would move 20% more than the overall market.
There is more than one way to calculate betas. One of the variables in the beta calculation is how far back you go with the calculation. Some calculations are based on three years of data, while others are based on five years of numbers.
These variables and others can make a difference in the beta that is reported.
Most sites don’t provide information on how many of their numbers were calculated—many sites buy the data from vendors.
Your best bet is to stick with names you know and trust and if you want to compare companies, use the same website since the numbers should be consistent that way.
How to Use It
What does beta tell investors? It is sometimes lost in the noise of the market.
One thing it doesn’t tell us is what the beta will be next year. The calculations are strictly historical and say nothing about what the company will do in the future. Beta is useful in the short-term for measuring the risk of the stock’s price if it fluctuates in a manner that we may not be comfortable with.
Beta tells us how the stock reacts to market-wide or systemic conditions, but tells us nothing about the company’s strengths or weaknesses within its industry.
For example, beta may tell us how a stock will react to a change in interest rates relative to the whole market.
However, it won’t tell us anything about the effect of legislation on the importers of oranges, but that could have a very important impact on a handful of businesses.
Get your financial information from the same source if you are going to compare companies. That way, you know the data collection and analysis is consistent. Beta is helpful in determining the likelihood of price swings in the near term, but not so reliable when looking at the long-term picture.