The Beta of an investment, also known as the Beta Coefficient or β, is a financial term that indicates whether an investment fluctuates more or less than the whole market average. A Beta of more than 1 suggests that the investment is more volatile than the market, while one of less than 1 indicates a below-market volatility, i.e. it is likely to fluctuate in price less than the average of the whole market.
Volatility is measured as the fluctuation of the price around the standard deviation – the mean.
The Beta is a measure of the risk of an asset in relation to the market, such as the S&P500 in the US, the FTSE 100 in the UK, the CAC 40 in France, or to an alternative benchmark or factors.
Selling T-shirts is about as risky as the market average, hence it has a Beta of one. Selling sandwiches is seen as the least risky of all three – we all need to eat – so it has a Beta of 0.75; it is less risky than the overall market average. Selling perfume, on the other hand, is comparatively risky, and is given a Beta of 1.5.
Important issues when using Beta
When using Beta, there are several factors the investor needs to be aware of:
– through time Betas may change;
– depending on the direction of the market, Betas may be different, i.e. they might be greater for downward movements in the market instead of upward movements;
– if the asset/security does not frequently trade, the estimated Beta will be biased;
– the investor may need multiple Betas to have a complete measure of risk.
According to NASDAQ’s glossary of terms, the Beta is a measure of co-movement and not volatility. A security might have a zero Beta and greater volatility than the market.
Beta is a measure of risk that arises from exposure to general market movement, rather than idiosyncratic factors. Idiosyncratic risk refers to risk that affects just one company or sector. The market portfolio of every investable asset combined has a Beta of precisely 1.
If Gold and Treasury Bills have a Beta of 1.5 and 0.5 respectively, they will go up and down 50% more and 50% less respectively than the market average. If the market average rises by 2%, Gold will rise by 3% and Treasury Bills by 1%. If the market average falls by -1%, Treasury Bills will fall by -0.5% and gold by -1.5%.
The Betas of treasury bills vs. gold
A treasury bill, for example, has a price that does not fluctuate much, therefore it has a low Beta. Gold, on the other hand, is susceptible to swings, which can sometimes be quite large – the fluctuations do not necessarily move in the same direction as or simultaneously with the market.
If a Beta is greater than one, it means that the asset is both volatile and has the tendency to move up and down with the market, such as a stock in a large tech firm. However, negative Betas may tend to go down when the market is rising, or up when the market is in decline.
Some fundamental investments have consistent and significant negative Betas, however, some derivatives such as put options may have large negative Betas.
According to lexicon.ft.com, the Beta is:
“A measure of a stock’s risk of volatility compared to the overall market. The market’s Beta coefficient is 1.00.”
“Any stock with a Beta higher than 1.00 is considered more volatile than the market, and therefore riskier to hold, whereas a stock with a Beta lower than 1.00 is expected to rise or fall more slowly than the market.”
Looking at it in strictly percentage terms, an investment with a Beta of 0.75 will probably fluctuate – go up or down – by 0.75% if the market fluctuates by 1%.
Investors like to hold onto low-beta stocks, also called defensive stocks, when the market is particularly volatile or on a downward trend.
High-beta stocks are more popular when the market is on a steady rise and investors are more willing to take greater risks in order to gain potentially bigger returns.
Denis Alaev says regarding the Beta formula: “You need to know something about Covariance matrix and variance, math and statistical stuff and able to use math tools or at least Excel for calculations.” (Image: qph.ec.quoracdn.net)
Other meanings of Beta or β
In lay or technical/scientific English, the word ‘Beta’ has literally dozens of different means. Here are a few of them:
Technology & Computing: 1. A beta release occurs before an official release – the term is commonly used for software in the development stage. 2. BETA is a progamming language. 3. The common-emmitter current gain of a bipolar junction transistor.
Biology: 1. A rank in a community of social animals (alpha female, beta female…). 2. A beta-endorphin is a type of neurotransmitter. 3. A beta cell is a type of cell in the pancreas that produces insulin. 4. A beta (plant) is a genus of flowering plants, generally referred to as beets. 5. A beta grape is a North American variety of grape.
Physics: 1. Beta velocity is something’s speed relative to the speed of light. 2. The ratio of thermal to magnetic pressure in plasma. 3. Beta function is a function in quantum field theory. 4. Beta particles are high-energy electrons or positrons emitted by certain kinds of radioactive nuclei.
Mathematics & Statistics: 1. β – the likelihood of a Type II error in statistics. 2. β-reduction is a reduction rule for lambda calculus. 3. In statistics, beta distribution is a family of continuous probability distributions.
Video – What is the Beta?
This ESCP Europe video explains the meaning of The Beta when used in the world of business and finance in easy-to-understand terms and examples.