Beta Coefficient

Definition

The investing term beta coefficient refers to a measure of an asset's volatility relative to a benchmark.  Betas are frequently calculated for individual stocks using a benchmark that is representative of the overall stock market.

Calculation

Beta = Covariance (Asset versus Benchmark) / Variance of the Benchmark

As frequently used in the analysis of stocks:

Stock Beta = Covariance (Stock versus Market Returns) / Variance of the Stock Market

An online beta spreadsheet is available to perform these calculations.

Explanation

Also referred to as financial elasticity, beta is a measure of statistical variance and uses regression analysis to compare how a single stock moves in relation to the stock market.   Typically, an index such as the S&P 500 is used as a benchmark, or proxy, for the entire stock market.

Interpreting beta is fairly straightforward and requires the knowledge of only four rules:

• Beta < 1.0:  over time, the volatility of the stock's price is less than that of the market index.
• Beta > 1.0:  over time, the volatility of the stock's price is greater than that of the market index.
• Positive Beta:  over time, the stock's price moves in the same direction as the market index.
• Negative Beta:  over time, the stock's price moves in the opposite direction from the market index.

Beta is a measure of risk, and the volatility of an individual stock cannot be mitigated through diversification.  It's also an important component of the capital asset pricing model formula.  While beta is certainly helpful in understanding the volatility of a stock versus the entire market, it's also a historical measure and should be used with caution.  Past performance is never a guarantee of future returns.

Example

The movement of Company A's stock over the last three years was measured against the S&P 500 Index.  The beta spreadsheet referenced earlier indicates Company A's beta was 0.72.  The interpretation of this value is as follows:

Since the beta is less than 1.0, Company A's stock price swings were less volatile than the entire market.  In fact, they move at a rate that was 72% of the market's fluctuations.  In addition, since it is a positive value, Company A's stock typically moved in the same direction as the market.  That is to say, when the S&P 500 Index increased on a given day, Company A's stock would increase too (in general).