Betas Aid in Stock Trading - but Which Do You Use?
Beta is a measure of the market risk or volatility of investing in a stock. It helps investors pick stocks that fall in their risk comfort zone.
But what does it tell you about a stock and what mixed signals do investors get when three different Web sites report three different betas for the same stock?
The last part of that question came from a reader, Dan R., who wondered why three Web sites gave him three different answers to the same question about a stock’s beta and one answer was apparently much different from the other two.
Let’s deal with Dan’s question first, and then talk about what a beta tells us. First, a refresher on what a beta is.
Beta is a score that measures a stock’s volatility or risk against the rest of the market. It is calculated using regression analysis.
The market, which is usually the S&P 500 Index, is given a beta of 1. If the stock is more volatile than the market, its beta will be more than 1, and if it is less volatile than the market, its beta will be less than 1.
For example, a stock with a beta of 0.8 would be expected to return 80 percent as much as the overall market. A stock with a beta of 1.2 would move 20 percent more than the overall market.
Dan in his asked if there were more than one way to calculate betas. Unfortunately, the answer is yes, there is.
One of the variables in the beta calculation is how far back you go with the calculation. Some calculations are based on three years of data, while others are based on five years of numbers.
These variables and others can make a difference in the beta that is reported.
Most sites don’t provide information on how many of their numbers were calculated – many sites buy the data from vendors.
Your best bet is to stick with names you know and trust and if you want to compare companies, use the same Web site since the numbers should be consistent that way.
What does beta tell investors? It is sometimes lost in the noise of the market.
One thing it doesn’t tell us is what the beta will be next year. The calculations are strictly historical and say nothing about what the company will do in the future.
Beta is useful in the short-term for measuring the risk of the stock’s price fluctuating in a manner that we may not be comfortable with.
Beta tells us how the stock reacts to market-wide or systemic conditions, but tells us nothing about the company’s strengths or weaknesses within its industry.
For example, the beta will tell us how a stock will react relative to the whole market to a change in interest rates.
However, it won’t tell us anything about the effect of legislation on the importers of oranges, but that could have a very important impact on a handful of businesses.
Get your financial information from the same source if you are going to compare companies that way you know the data collection and analysis is consistent. Beta is helpful in determining the likelihood of price swings in the near term, but not so reliable when looking at the long-term picture.