What is beta and HOW would it be relevant to a stock trade?
Give an example.
Best Answer
265 points
MaverickInvestor answered one year ago …
Beta is simply a measure of volatility.
I've no idea how it's worked out! But this is how you use it...
If beta = 1 for a stock, then you can expect that stock to move in line with the market. So, if you have a view that the S&P is headed north, then any stock within that index with a beta of 1 will likely go north, too, at roughly the same pace.
If beta = 0.8, for example, then the stock is less volatile, and so can be expected to move less than the market. Utility stocks often fall into this category.
If beta = 1.3, then I'm sure you can guess the rest! The stock in question is about 30% more volatile than the market, so when the market drops hard, a high-beta stock can be expected to drop even harder. Hi-tech and bio-tech stocks often fit this profile.
Answers
4085 points
EthanR answered one year ago …
Maverick has nailed it. As for how it is worked out, Beta is calculated using regression analysis, but I don't know if there is a formula or not.
According to Wikipedia, "Regression analysis is a technique used for the modeling and analysis of numerical data consisting of values of a dependent variable (response variable) and of one or more independent variables (explanatory variables). The dependent variable in the regression equation is modeled as a function of the independent variables, corresponding parameters ("constants"), and an error term. The error term is treated as a random variable. It represents unexplained variation in the dependent variable. The parameters are estimated so as to give a "best fit" of the data. Most commonly the best fit is evaluated by using the least squares method, but other criteria have also been used."
2775 points
Oldman answered one year ago …
In market jargon, there are several types of "beta" calculations, but they all generally refer to the relative volatility of the security's price vs some reference (comparison). Beta is the standard deviartons of price fluctuations...and when compared to a reference index, such as the S&P 500, the larger the beta of an individual security, the greater its variation in market pricing is when compared to the S&P...up more when the S&P is up; down more when the S&P is down.
EthanR's notation of the variance (std. deviation squared = sum of squares by which the track of a security's price varies from some average or reference) is accurate, for trend and technical analysis) and I think the types of technical indicators, such as MACD or Bollinger Bands (the range of the std. deviation above and below the periodic pricing), are key indicators for timing a purchase or sale of a security. One would want to purchase when the security's trend is significantly below a long term trend, but only if it has a history of cycling back above ...otherwise, it might get even cheaper!
Bets is a measure of "risk", and needs to be considered in connection with the correlation of the security's market price with the overall index. (If you compared the "std. deviation" of the prices paid for e.g., Consolidated Edison, to the variations in pricing of the S&P 500, the beta of ED would seem low, because the price isn't well correlated with that of the S&P.) Indeed, electric utilities usually rise in price when interest rates fall, but not when there's a credit crunch, since they need to issue bonds to finance long-term development and infrastructural repairs.
In addition, "Beta" is a measure of the pricing variable, while "Alpha" is a measure of the excess return of a component of a portfolio, compared to the comparison index, or the portfolio of which it is a component. Utilities that have a steady or increasing dividend payment always have a greater "Alpha" than those utilities that don't pay dividends...because the investor gets some return, even if the security is NOT sold.
The ideal security has a low beta, and a high alpha...and very few exist over any period longer than a few days.
