What is beta?
Beta is a measurement that illustrates the volatility of an individual company’s shares, or a particular asset, when compared with the rest of the market. Investors can use this information to estimate potential returns and assess risk.
How beta is measured
Beta scores need a benchmark so investors have a point of comparison. As a result, markets are normally given a beta of 1 – and stock is scored in relation to this figure. If a company’s stock was awarded a beta of 1.4, this would suggest that its shares are 40% more volatile than the market average. Meanwhile, a beta of 0.8 would mean it is 20% less volatile by comparison. Negative beta, with a score of less than 0, is also possible if an asset performs strongly when the market is in decline.
There are certain assets which are more prone to lower beta scores. Companies with share prices that don’t seem to respond to major market events often fall into this category – but as a result, this low-risk status can mean there is little scope for profitability from an investor’s perspective.
Why it matters
Beta can be a useful tool in helping investors determine the risk-reward ratio they are looking for. However, it isn’t perfect – and measuring volatility based on past performance doesn’t necessarily provide an accurate picture of what’s going to happen in the future. Generally, short-term investors will have more use for beta than those who are in it for the long term.
It’s also worth bearing in mind that beta doesn’t always take into account changes in a company’s circumstances. While a business may have had low beta before, this score may not reflect recent changes that make its stock riskier, such as an increasing level of debt. Meanwhile, for firms that have just completed their initial public offerings, there often isn’t enough information to gauge how volatile they will be compared with the rest of the market.