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 in probability and statistics and the difficulty of calculating the number by hand. Investors should not be wary 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?
A 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. In the investing industry, beta coefficient is the universal measure 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, then multiplied by a correlation between the two. Luckily, investors can find any stock or mutual fund’s beta coefficient already calculated on most financial websites, such as Yahoo Finance, Bloomberg and Google Finance.
How Betas Inform Investing
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 percent 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 percent 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 the ups and downs of the stock market. Understanding the beta coefficient of the stocks and other investments you own is one more tool to increase your knowledge as an investor. Whether they pick individual stocks for their portfolios or leave a mutual fund manager to find and manage them as a fund, investors should continually work to increase their knowledge about their investments. Understanding how the beta coefficient is calculated and used can only help that endeavor.
This article is by Hank Coleman. Hank is a financial planner and writer.