Beta is a measure of a securities volatility when compared to the market or benchmark as a whole. This is also known a systematic risk, which is also known as undiversifiable risk that affects the overall market. Beta is a useful measure for setting investor expectations about the volatility of a portfolio and how individual securities impact on that volatility.
A beta of 1 means the security has the same volatility as the market, meaning a 1% move in the market is expected to be matched by the security. Readings of less than one means the security is less volatile than the market, conversely readings above one means the security is more volatile than the market. Generally beta will be positive however when a security is inversely correlated with the market, such as inverse ETFs or put options, the beta will be negative.
The image below illustrates the 60-day beta for Apple Inc. (AAPL), while this has typically been greater than one, there a two periods where beta has declined sharply in April 2019 and March 2020. This emphasises the changing nature of beta, particularly over short periods.
Generally investors will be very happy to hold high beta stocks when the market is trending higher, as the portfolio of high beta securities will rise even further. The downside to this is that in a downturn, high beta stocks will fall further than the market. With human psychology, losses feel more painful than the positive feeling derived from profits. Therefore, when the market turns lower investors with high beta portfolios can experience high levels of stress as their portfolio value decreases by more than the market.
While beta can be useful when evaluating a stock it does have some limitations. Beta does not by itself tell investors about the direction of a trend, a security with a low beta may have lower volatility but could still be in a down-trend. The calculation is also subject to lookback periods which can significantly change the value, particularly if the volatility changes over a short period. Additionally, historical data is used in the calculations, and while this may give an indication, it is not a perfect predictor of future volatility.
Therefore beta can be a useful measurement in setting investor expectations to the risk of a security and the overall volatility that can be expected in a portfolio’s value. However it is not a perfect measure of risk and should always be used along with further analysis before making investment decisions.
