Who: This post is for people who have read a mutual fund prospectus or a research report and wondered what this mysterious “beta” number means.
What: This post will discuss the concept of beta with a general overview followed by a slightly more mathematical perspective.

So, What is it?

Simply speaking, beta is a measure of the volatility, or risk, associated with an investment (or portfolio of investments) as compared to the entire market as a whole. A baseline beta is 1, which means that an investment’s volatility, or price movements are similar to the market’s price movements. A beta below 1 means that an investment is less volatile than the market and as you may expect, a beta above one means that an investment is more volatile than the market.

An Example: Did you Expect Anything Less?

To give you a more intuitive sense of how beta shows volatility, we can use an example of 3 stocks (A, B, and C). Stock A has a beta of 0.75, Stock B has a beta of 1.0 and Stock C has a beta of 2.0. If over the course of a year, the market rises 10%, the betas would indicate that the tendency of each of these stocks would be as follows: Stock A would move 0.75% for each 1% movement of the market, Stock B would move 1% for each 1% movement of the market, and Stock C would move 2% for each 1% movement of the market. Ultimately, one would expect the returns for the stocks to approach 7.5%, 10%, and 20% for the year, respectively.

From this example it might seem like Stock C would be a clear choice for your investment. However, keep in mind that this same system applies to decreases in the market. If the market declines 15%, you would tend to see Stock C’s price plummet 30%. As stated earlier, beta is just a measure of volatility with respect to the market, both positive and negative volatility are included in this calculation.

Calculating Beta in Excel

Calculating the Beta itself requires a linear regression, which is somewhat tedious and difficult by hand. Maybe one day I will go through those motions, but I don’t feel like it today :-). In Microsoft Excel, however, the calculation of beta is very simple. All you need are daily, weekly, or monthly returns for the investment that you want to calculate the beta for as well as the same information for the market index that you would like to use as a baseline for comparison. For example if you are looking to compare volatility with respect to an index of large companies, you may want to use the DJIA or S&P500. If you want to try something which tracks smaller companies, the Russell 2000 might be a better idea.

Using the LINEST() formula, you just input the company returns as the first set of cells and then enter the index returns as the second set of cells. So if your company returns were in column A, and the index returns were in the column B, your formula would look something like this: LINEST(A1:A300,B1:B300). Voila, you’ve got your calculation of beta.

How to obtain these returns (i.e. the values on the columns) is an entirely different concept, one which deserves coverage. I will discuss this in my post on stock research in the upcoming weeks.

Utility of Beta

As I alluded to above, Beta can be used as a proxy for assessing risk of a stock. If you want to play it safe, you will want to find stocks with a low beta, as they tend to react to price movements in the market to a much lesser extent than do stocks with higher betas.

But nothing is perfect…

Shortcomings of Beta

  • Beta is backwards looking - As with many metrics discussed on this site so far, beta is backwards looking. This means that beta is calculated based on information from the past. This may be significant if a company that you are reviewing is brand new. In this scenario, there may be insufficient stock price history to determine a reliable beta for the company. Additionally, beta calculations fail to incorporate future expectations and information about a stock. If a company is entering a new industry, branching out, or doing something potentially more risky (or cautious) than it’s normal operations, beta will not reflect this change for a long period of time.
  • Beta requires a market index - In order to calculate the beta of a stock or fund, one must compare it to a baseline, or market index. In other words, an investment as a beta of X with respect to a given market index. For most stocks the S&P 500 is used and for smaller companies, one may use the Russell 2000, etc. This becomes problematic if an index does not exist that can be considered a good baseline measure for the investment whose beta you wish to calculate.
  • Beta is unreliable in the long term - This is related to the first drawback, but I will expand on it a little bit more. Over a short period of time, certain characteristics of a company may lead to a calculation of beta as 1 or slightly below 1 but if over time, the company’s status changes, market capitalization rises, or operations vary, then the beta may change drastically. In other words, beta should not be used as a long term assessment of a company’s risk.
  • Beta makes value investors cry - As we all know there is downside risk and upside “risk.” The former is considered “bad” and the latter is considered “good” but unfortunately, beta does not distinguish between the two. For companies that have declined in value over a period of time, the beta may be high because of the price fluctuations. Many technical analysts would consider this to be a high risk (high beta) stock while value investors may see it as an opportunity to invest in an undervalued company.

Wrappin’ it Up with a Bow

I hope this has served as a good overview of the beta measure, how it can be used, and the caveats to keep in mind when using the measure. I realize that there was not much in terms of the mathematics of Beta covered here, but I strayed from that for two reasons. I have received some feedback that my posts are a bit too “daunting” so I will try to keep it simple for a little while and see how people feel about that. Additionally, I think I will try to split my “hardcore” and simpler posts up so people can pick and choose what they would like to read. Please, throw some more comments my way, I’d love to hear them.

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