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One characteristic of stocks and mutual funds that is not talked about much among novice to intermediate investors is the beta coefficient. Many people are made immediately nervous when discussing the beta coefficient because of its roots based in probability and statistics and the difficulty of calculating the number by hand. Investors should not be weary of this number because it is given to you in most cases and it can help ensure that your investment portfolio is properly diversified.

What Is A Beta Coefficient?

beta coefficients help show volatilityA stock or other investment’s beta coefficient is a measurement of its risk when comparing that single stock to the broader market as a whole. A stock’s beta coefficient is the universal measure in the investing industry of systematic risk, or market risk of fluctuating market prices, and it shows an investment’s volatility. Specifically, the beta coefficient is a measurement of the stock’s standard deviation divided by the market’s standard deviation and then multiplied by a correlation between the two. Luckily, investors can find any stock or mutual fund’s beta coefficient already calculated for you on most financial websites such as Yahoo Finance, Bloomberg, and Google Finance.

Why You Should Monitor Your Investments’ Betas

So, what does this very technically derived number mean to the average investor? A beta of 1.0 means that the investor’s stock or investment moves in direct coordination with the rest of the stock market. An 8% return of the total stock market should result in the same corresponding return of a stock with a beta of 1.0. A stock with a higher beta indicates that it would be seen as a more aggressive stock than the rest of the market and investors could expect price swings.

Investors would expect that the stock’s highs would be higher than the broader market and the lows during a recession would be more severe. A stock with a lower beta, 0.7 for example, could expect only a 70% rise from where the total market would increase. A lower beta may indicate a lower risk stock with less volatility than the overall market. The lower beta stock may not rise as fast as the overall market but most likely will also not fall as fast either.

Why You Should Monitor Your Investments’ Betas

Your stock and mutual fund betas are a great tool to use to ensure that you are properly diversified. You most likely do not want to have stocks with the exact same betas moving in lock step with the overall market in your portfolio. A well diversified portfolio of stocks may have some stocks with high betas and some with low betas in addition to stock with a beta of 1.0 in order to help ensure that portions of your portfolio are doing well during most periods of the market.

A well-diversified investment portfolio will help smooth out the ups and downs of the stock market. Understanding the beta coefficient of the stocks and other investments you own is just another tool that can be used to increase your knowledge as an investor. Whether we are picking our own individual stocks in our portfolio or leave a mutual fund manager to find and manage the investments for us, investors should continue to strive to increase their knowledge about their investments. Understanding the underlying calculations of the beta coefficient and how it is used can only help improve our ability to invest more efficiently and diversify our holdings.

This article is by Hank Coleman. Hank is a financial planner and writer.

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