Provided by Benjamin F. Edwards & Co.
Spend enough time reading about investing and you’ll come across the term “beta” to describe a stock’s level of risk. What does it mean? Should you consider it when deciding what stocks to buy?
We’ll explore this, and related terms, in today’s column.
Trying to quantify risk
Investment professionals have a method for calculating what level of investment returns should be expected from the market, as a whole, in return for the risk of owning stocks. From there, an individual stock (or a mutual fund of stocks or even a sector) is determined to have a level of risk in comparison to the overall market. The number that is generated by these calculations is called “beta.”
A stock that was no more or less risky than the overall market would be given a beta value of
- Those that are riskier have a number above one, representing a percentage of relative risk. Those that are below are less than one. Theoretically, a negative beta is possible, but too rare to be worth discussing here.
If a stock is riskier than the rest of the market, theoretically it should earn more of a return, to compensate for that risk. Conversely, one that is less risky should earn less. And in theory, these differences should be magnified by movements in the market. A riskier stock – one with a higher beta – should jump more in a bull market and fall more in a bear market. In other words, it’s more volatile.
Risky stocks are those that, in the right circumstances, are poised for growth, such as technology firms or alternative energy companies. Less risky stocks tend to be those that deal with stable products and services, such as utility companies and discount stores.
The beta number is intended to indicate how much a stock will move in relation to the market. A stock with a beta of 2 would be twice as volatile as the market. It would be expected to go up by 20% if the market goes up by 10%. At the same time, a stock with a beta of 0.5 – half as volatile as the market overall — would be expected to gain only 5% in
this example. Conversely, the stock with the beta of 2 would be expected to plummet by 20% if the market dropped by 10%, while the 0.5 beta stock would theoretically slip by just 5%.
Balancing risk and reward
There’s a way of measuring the potential for a stock to do better than expected against similar stocks as well, and that’s called “alpha.” And finally, investment firms will discuss a stock or fund’s overall balance of risk versus reward with something called the “Sharpe ratio.”
That’s the framework, at least. But how much should you count on it? For buying or selling a single stock, these predictors are far from a sure thing.
What inexperienced investors sometimes overlook is that the numbers are all based on the past performance of the stock or mutual fund in question. As the investment refrain goes, past results are not a guarantee of future performance. A stock with a low beta is not immune from sudden changes that make its value plummet. One with a high beta may face sudden competitive headwinds that halt its expected progress.
Beta, alpha and the Sharpe ratio are just guidelines – numbers that tell you something of the stock’s risk/reward level. But considered collectively for a portfolio of stocks, they can be useful. Considered with other factors, they can help you or your financial advisor make investment decisions that could result in a reasonable expectation of gains without undue losses.
This article is provided by and was prepared by or in cooperation with Benjamin F. Edwards & Co. The information included in this article is not intended to be used as the primary basis for making investment decisions nor should it be construed as a recommendation to buy or sell any specific security. Benjamin F. Edwards & Co. does not endorse this organization or publication. Consult your investment professional for additional information and guidance. Benjamin F. Edwards does not provide tax or legal advice.
Benjamin F. Edwards & Co., Member SIPC and FINRA