When it comes to picking stocks, everyone knows about alpha. We’re all looking for alpha, or outperformance, when trading or investing in stocks. Alpha is the difference between a stock’s return and the total return of a benchmark index – a high alpha stock is one that beats the market. Even if you weren’t aware of the term, you were trying to capture what it symbolizes. Otherwise, why even bother picking stocks?
Working in conjunction with alpha is beta, but unlike the terminology you’re accustomed to in the real world, beta doesn’t mean inferior or secondary. Beta refers to a stock’s volatility in relation to the market, which may sound similar to alpha, but the two are actually quite different. Even the most conservative investor wants nothing to do with a low alpha stock. But a low beta stock? That might be acceptable, or even ideal, to a particular cohort of investors.
Beta is a measure of volatility that helps investors gauge the risk of a particular stock. When calculating beta, the movement of the stock is compared to the movement of the market as a whole (which in most cases means the S&P 500). The market has a beta of 1, regardless of whether it’s up 10% or down 30%. The beta of the stock refers to the change in return compared to this market average.
For example, in 2021, the S&P 500 returned an impressive 27%. But not every stock in the index returned 27% – some did worse, some did better. One of the big winners of 2021 was Tesla Motors (NSDQ: TSLA), which was up 45% in 2021. This would give TSLA a beta coefficient of 1.6 since the stock outperformed the index by 60% (27/45 = 0.6). On the other hand, Duke Energy (NYSE: DUK) was up 20% in 2021, a good return but less than the overall market average. In this time period, DUK had a beta coefficient of 0.74 since it provided a return equal to 74% of the total market return.
Beta is a crucial component in the Capital Asset Pricing Model (CAPM), a formula used by investors and asset managers to calculate the risk of a portfolio. CAPM calculates the expected return of a security through an equation using beta, the expected market return, and the risk-free rate (ie. long-term government bonds). The CAPM looks something like this:
Expected Stock Return =
Risk-free Rate + [Beta * (Expected Market Return – Risk-free Rate)
Beta changes depending on the time frame being measured, so it’s a tool that must be used in conjunction with other signals when building a portfolio. Markets don’t tend to signal their big moves and sudden moves can render a stock’s beta useless.
Calculating beta in the Capital Asset Pricing Model is a form of regression analysis, a type of analysis that compares dependent and independent variables. We used a brief example above to discuss how the beta coefficient is calculated, but there’s a formula that can be used in Excel to show beta as a sloping graph. The formula is:
Beta = Covariance (Stock Return, Market Return) / Variance (Market Return)
You’ll need to record the daily or weekly price of the stock AND the overall market price over your particular time frame in order to perform the analysis.
Advantages of Beta
Beta is a useful tool when measuring the risk profile of a portfolio because it gives investors a hard number to use. A stock with a beta of 1.3 added to a portfolio with a beta of 1 will make the portfolio riskier on average than the overall market. But a stock with a beta of 1.3 added to a portfolio carrying a 1.6 will actually make that particular portfolio less risky. In many cases, the risk is a matter of personal perspective. A portfolio with a beta coefficient of 1 is easy to compare to the market, but a portfolio with a beta coefficient of 0.74 or 1.6 makes things more complicated.
Here are some of the advantages of using beta when evaluating stocks:
- Easily digestible number
- Allows easy comparison of systematic and unsystematic risk in a portfolio
- Helps investors make better-informed decisions about the riskiness of their investments
Disadvantages of Beta
Of course, no trading signal or measure is perfect, and using beta has its deficiencies too. The primary disadvantage of beta is that it uses historical performance to measure the volatility (and therefore riskiness) of a stock. But as you’ve undoubtedly heard, past performance is no guarantee of future performance. If a stock has a beta of 0.5 over a five-year span, it’s not a guarantee that the next five will show a similar level of volatility. Ask those who invested in AMC or GME before 2020 about how useful beta was when calculating the risk in those securities.
Since beta uses historical pricing data, it’s slow to react to the news. A stock like Enron wouldn’t have sent any warning signs through beta that an accounting scandal was about to unfold. Beta is also less useful when comparing the volatility of a stock like a drug manufacturer, whose prospects could skyrocket or plummet based on a single trial or test result. Backward-looking statistics like price data will always have limitations since the future can’t be predicted by previous prices.
Assessing the Risk
What exactly is risk? The possibility of loss? The unpredictability of stock returns? We tend to think of risky stocks as ones with the greater potential to lose money, but risky stocks on average will produce superior returns during bull markets. Every individual investor will have a different risk tolerance and perhaps even a different opinion on the reliability of beta.
Beta often works better in theory than in practice. Stocks don’t have a nice, equal distribution of prices. As the old saying goes, stocks take the stairs up and the elevator down. An analysis of past price data in a neat little set may hide unseen risks. Overall market returns aren’t set in stone and individual stocks can be as unpredictable as winter weather. Beta can only go so far when measuring the true risk of a stock.
Like all statistical measures of stock performance, beta is useful in certain contexts. Yes, past performance can be unrelated to future performance, but unless you have a Delorean with a working flux capacitor, you won’t be able to obtain future prices for your data set. The only thing we have to use is price data from the past and in that regard, beta can be a useful guidepost for determining the overall risk of a portfolio of different stocks.
More high beta stocks mean more risk, but also potentially more reward. Low beta stocks may not match market returns, but your risk of capital loss is minimized. However, markets have a tendency of making even the smartest, most calculated investors look foolish. Don’t rely solely on beta when building your stock portfolio. It may help sort systematic and unsystematic risk, but it won’t stop your investments from losing money in a downturn.