A positive alpha indicates outperformance, while a negative alpha suggests underperformance relative to the benchmark. A portfolio consisting entirely of high-beta stocks can be highly volatile and subject to significant market fluctuations. Conversely, a portfolio with primarily low-beta stocks might offer stability but potentially limit returns. Balancing high and low-beta assets allows investors to tailor their portfolios to their specific risk-reward preferences. Beta is a measure of volatility relative to a benchmark, and it’s actually easier to talk about beta first. It measures the systematic risk of a security or a portfolio compared with an index like the S&P 500.
It’s tempting to just look at the number on your brokerage’s app or website and assume you know how volatile that particular stock or asset is. But those assumptions require verification because beta isn’t universal. The offers that appear on this site are from companies that compensate us. But this compensation does not influence the information we publish, or the reviews that you see on this site.
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For every 1% move in the market, Proctor & Gamble’s shares moved 0.42% on average. That’s good in terms of protecting against losses but also means limited upside potential compared to other options. More conservative investors or those that wish to soon tap into their funds will likely prefer low-beta stocks. These kinds of stocks historically tend to not fluctuate much in value. They are companies that consistently deliver steady revenues and profits in times of economic expansion and hardship. Positive or negative surprises are lacking and valuations are based on very realistic expectations that the company has a history of reaching.
So, beta can only take into account the effects of market-wide risks on the stock. Essentially, beta expresses the trade-off between minimizing risk and maximizing return. On the other hand, if the market declines 6%, investors in that company can expect a loss of 12%. An investor uses beta to gauge how much risk a stock adds to a portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns.
Defining Alpha
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Investing
Beta is a statistical measure that compares the volatility of a particular stock’s price movements to the overall market. In simple terms, it indicates how much the price of a specific security will move in relation to market movements. A beta of 1.0 indicates that the security’s price will move with the market. A bell+howell clever grip pro magnetic portable phone mount as seen on tv beta less than 1.0 suggests the security will be less volatile than the market, while a beta greater than 1.0 indicates the security will be more volatile. Beta measures how volatile a stock is in relation to the broader stock market over time.
Investors buy the stock based on it living up to its potential, which requires lots of uncertain factors going its way. A slip-up could result in the share price tumbling dramatically. Likewise, a small hint of good news can lead to another big rally.
How to Interpret a Stock’s Beta
Beta values can shift over time because they’re tied to market fluctuations. Investors use beta to align their portfolios with their risk tolerance levels, targeting high-beta stocks for potentially higher 3 moving average crossover strategy returns with more risk, or low-beta stocks for added stability. Beta is used in the capital asset pricing model (CAPM), a widely used method for pricing risky securities and for generating estimates of the expected returns of assets, particularly stocks. In this way, beta can impact a stock’s expected rate of return and share valuation.
- Unsystemic risk is unique to each security and can be diversified away in an investment portfolio.
- Beta represents the slope of the line through a regression of data points.
- In this case, covariance will show you how changes in stock returns relate to changes in market returns.
- The calculation helps investors understand whether a stock moves in the same direction as the rest of the market.
Beta is an integral part of the capital asset pricing model, and all traders and investors use it. Beta can evaluate risk by comparing a stock’s price movements against an individual portfolio and expressing how much volatility that particular stock will add to the asset base. A security’s beta is calculated by dividing the product of the covariance of the security’s returns and the market’s returns by the variance of the market’s returns over a specified period.
Beta and the Capital Asset Pricing Model
An analyst will generally select an index most appropriate to compare with the chosen stock. For instance, the S&P 500 (Standard & Poor’s 500) can be used to calculate the beta of a large U.S. company. Growth stocks typically tend to have a high beta, indicating greater market volatility. What beta also tells you is when risk can’t be diversified away.
Typically, volatility is a sign of risk, with higher betas suggesting greater risk and lower betas projecting lower risk. Thus, stocks with more significant betas may gain more during bull markets. Alpha and beta are metrics that investors use to analyze the risk of a security or portfolio. The investor also wants to calculate the beta of Coca-Cola in comparison to the S&P 500.
A stock’s beta will change over time as it relates a stock’s performance to the returns of the overall market. For beta to provide useful insight, the market used as a benchmark should be related to the stock. For example, a bond ETF’s beta with the S&P 500 as the benchmark would not be helpful to an investor because bonds and stocks are too dissimilar. Alpha is excess What is low liquidity return in relation to a benchmark and is commonly used to reveal how much active fund managers outperform the index they are trying to beat.