Understanding a Stock's Beta

A stock's beta is a comparative measure of how the stock performs relative to the market as a whole. The basic premise is that a rising market generally tends to boost most stock values with it, while a falling market is apt to lower them. The beta is a calculated method of determining just how close the correlation between the two is.

To begin with, the market itself has been assigned a beta value of 1; in other words, its movement is exactly equal to itself (a 1:1 ratio). Stocks may have a beta value of less than, equal to or greater than 1. For example, if a stock has a beta of more than 1 (1.5, for instance), this indicates that when the market moves up or down, that stock is also likely to move up or down, but at a rate of 50 percent more than the market. Let's assume for a moment that the stock market rose 20 percent last year. The stock with a beta of 1.5 would have increased its value by about 30 percent, or approximately 50 percent more than the market's 20 percent rise. Similarly, if the market had fallen 10 percent instead of rising, that same stock would likely have fallen about 15 percent in value (note that this is still 50 percent more than the value of the market's movement).

Now let's imagine a stock that has a beta of less than 1: this stock can be expected to fluctuate less than the market as a whole. For instance, if a stock has a beta of 0.75, it will react 25 percent less strongly than the average ups and downs of the market. Using our 20 percent market-rise example again, the stock with a beta of 0.75 would rise in value by around 15 percent (or 3/4 of the market's rise). Again, if the market instead had fallen by 10 percent, the same stock would probably have fallen about 7.5 percent (3/4 of the market's movement). Additionally, stocks can have a negative beta; such securities would tend to move in the opposite direction of the market.

In general, securities that possess high betas are good to have when the market is rising. Unfortunately, they can wreak havoc on a portfolio when the market is moving in the other direction. Conversely, betas of less than 1 are better in falling markets. They tend not to drop in value as severely (but neither do they gain as much in good markets).

If, as conventional wisdom tells us, over time, good companies' stocks perform well and bad organizations' stocks do poorly, why should the beta matter at all? Many experts believe that the entire market dictates approximately 70 percent of an individual stock's movement, whether up or down, while the company's actual performance accounts for only the remaining 30 percent. According to this expert opinion, then, when you are evaluating a given stock for your portfolio and want to gauge its potential volatility in relation to the market as a whole, understanding the beta is invaluable.

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