What Is Beta?
Investment analysts use the Greek letter beta (β) to represent the measurement of a stock's relative market risk. It measures the degree to which a stock price fluctuates in relation to the overall market—otherwise known as the stock's volatility.
Where it Starts
The baseline for this measurement is the overall market, which has a beta of 1. Any stock with a beta greater than 1 is more volatile than the overall market. Any stock with a beta less than 1 is less volatile than the market. Let's look at a hypothetical situation to illustrate this point.
Some Illustrations of Beta
Say a hypothetical Internet company we will call Widget.com has a beta of 2.0. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return on investment of 8%. We would expect Widget.com to return 16%. However, if the market declines and were to provide a return of -5%, investors in Widget.com could expect a loss of 10% on their investment. Conversely, let's say that Local Telecom has a beta of 0.5. This means that it is half as volatile as the overall market. In our hypothetical market, then, Local Telecom should have a return on investment of only 4% when the market rises 8%, but should only have a negative return of 2.5% if the market drops by 5%.
Let Beta Influence Your Decision
Of our two companies, it is clear that Local Telecom is a much less volatile investment than Widget.com. However, Local Telecom's returns are also lower when the market has positive returns. This is the fundamental trade-off between risk and return. The beta equation helps investors identify the kinds of stocks that provide the degree of risk they are willing to accept, in order to achieve the gains they want.