Definition of beta (finance): Beta represents the correlation between movements in the price of a security, and price movements in the broader market for similar securities.
What is beta?
Beta is a greek letter, used in finance formulae to explain the sensitivity of an individual investment to price movements in the overall market. It is most commonly used to represent the sensitivity of a stock price to general movements in the whole stock market.
A beta of ‘1’ means that the individual asset price is expected to move directly in proportion to the wider market. For example, if you bought a share which had a beta of 1, then on a day where the stock market fell by 1%, you would expect that the share price of your individual share would fall by 1%.
Beta is an average, formed from historical data over a long period. Therefore, it is not a guaranteed predictor of future price sensitivity. It provides a general indication only.
Beta and the Capital Asset Pricing Model (CAPM)
Beta is most prominently featured in the Capital Asset Pricing Model, known as CAPM for short. The CAPM formulae shows that an investor’s expected return will include an element of return as follows:
The market premium * beta.
The market premium is defined as the average excess stock market return above the return of a risk-free asset (e.g. a government bond).
In other words, this excerpt from CAPM tells us that an investment with a beta of 1, should deliver the average market return of the stock market.
If an investment has a beta of 0.5, will see only half of the upward and downward swings (and therefore simplistically half the risk) of the broader stock market. In this case, CAPM predicts that an investor would only receive half of the market premium.
This is a basic concept, featuring in the best investing books, which underpins the principle of risk and reward which impacts all investing.
It emphasies that investors are always compensated for the degree of market risk which they take on.
Higher risk investments – those which are more volatile and gyrate in a more dramatic fashion – have a higher beta and this should result in a higher nominal return for the investor.
How is the word beta used in a sentence?
“Google Finance quotes the beta of XYZ PLC as being 0.9.”
What else you should know about beta?
Beta can be close to zero
Where the price of a company’s stock price barely moves in response to broader market movements, it will have a very low beta.
This doesn’t mean that the share price doesn’t move. On the contrary, it will still rise and fall in response to new information about its own prospects.
A low beta implies that this news and the price movements have little or no correlation to the broader market.
Companies with low beta usually include utility companies such as water providers. Their revenues and pricing is assured by the constant demand for water, and regulated water prices. This results in the growth in the stock price being muted turning economic booms, but likewise protects the share price from large downward swings in times of recession.
Beta can be negative
Where the share price of a company tends to move in the opposite direction to the stock market, this will produce a negative beta value.
Negative beta isn’t the same thing as a negative expected return – two shares can still climb upwards in price despite broadly having opposite daily price movements to each other.
Negative beta is a very desirable characteristic when buying shares, because it increases the diversification of a basket of stocks when building an investment portfolio. Shares with negative beta should post a gain on days when many other stocks in your portfolio will have fallen.
This could help to ‘smooth out’ the overall portfolio return, and therefore reduce its overall risk.
Negative beta shares are few and far between. Examples at the time of writing include Zoom Video Communications and China Online Education group, both listed in the US.
These companies probably have a negative beta because they have seen a surge in demand for their services at a time of lock-down and reduced economic activity in general. Therefore, their fortunes (and share prices) have moved in the opposite direction to the rest of the market during the pandemic of 2020/2021.
How does the definition of beta relate to investing?
Beta is a measure of risk and is a basic principle of investing that all investors should be familiar with.
Understanding risk and reward will allow you to ensure that your portfolio matches your personal risk tolerance.
Consider taking an investing course to explore the interesting subject of investment risk in further detail.