The Definition of Stock Market Beta

Beta can be a very useful tool to stock investors.

Stock investors need to understand the levels of risk when they purchase a stock. The beta measurement provides a value that represents a stock's volatility level as compared to the overall stock market. By using beta, traders can assign a value of volatility to their overall stock holdings.

Evaluating Stocks With Beta

One of the most critical factors to anyone investing in the stock market is their own personal level of risk aversion. In a nutshell, an investor's amount of reward is determined by their risk tolerance. When it comes to trading stocks, there is a direct correlation between risk and reward. Quite simply, high reward comes with high risk, and low reward comes with low risk. One helpful tool in assessing the risk associated with a given stock is its beta level. A stock's beta is a measure of its variability or volatility as compared to the stock market itself.

Understanding The Beta Measurement

Beta can give traders an idea of the risk they are adding to their portfolios when they buy stocks. If the beta is zero, then the stock price remains the same regardless of what the market does. A beta of 1.0 indicates that the stock's price tends to move directly with the market. A value of greater than 1.0 implies that the stock's volatility is greater than the overall stock market. A negative value of beta indicates an inverse relation to the market, but negative values are unlikely and could be data errors. Also, betas that are greater than 4.0 are false as well.

Using Beta When Stock Investing

Stock traders can easily manage their overall risk by monitoring the total beta of their stock holdings. For instance, conservative investors would maintain a lower portfolio beta between 0.0 and 1.0; whereas, investors seeking bigger returns might target a beta of between 1.5 and 2.0. Beta can also be used as a planning tool as well. For instance, suppose a trader is expecting an annual return of 15 percent for the total market. If he wants a return of 30 percent, then a stock with a beta of 2.0 would be chosen.

The Limitations Of Beta

While beta can be a useful tool, it does have some shortcomings. To begin with, it is based on historical data and does not consider new information. New data can permanently alter a company's landscape in a dramatic way. Secondly, past price movements of the financial markets can be very bad predictors of the future because of all the complex factors involved. Thus, beta tends to be more useful in shorter time periods, and is less useful in the long term.

Keeping Beta In Perspective

Anyone investing in the stock markets must address their personal risk tolerance if they want to be profitable. Beta is a nice tool to use as a general benchmark to evaluate how much volatility their portfolios are withstanding. However, investors must be vigilant and monitor current data that might affect their stock holdings which will not be reflected in the beta measurement of their portfolios. Thus, their trading plans need to address these market changes.

References

• Investopedia: Beta--Know The Risk
• Investopedia: Beta--Gauging Price Fluctuations