Beta Ratio Basics

In order to measure the volatility of the price of a stock relative to the rest of the market you should apply the Beta ratio. It represents one of the commonly misused financial ratios with which, however, you should be well familiar.

Beta ratio provides you with information on the movement of the price of the stock as compared to the rest of the stock market. You can also use the beta of a stock to compare it with its peers from the same industry or sector to see whether it is underperforming or performing accordingly.

Beta Value Analysis

You are not required to make the calculations of Beta on your own, since they are done using regression analysis. Different software is available for these purposes. You can always refer to one of the many online sources that provide beta information. Such a source is Reuters.com.

Most often the S&P 500 is used to calculate the beta, although many other indexes may be used. A value of 1 is assigned to the whole market.  

If the beta value of a stock is more than 1, then the price of this stock is considered volatile as compared to the overall market. Thus the stock is classified as risky.

If the beta value of a stock is equal to 1, then the price of the stock fluctuates at the same level as the market.

If the beta value of a stock is less than 1, then the price of the stock is less volatile as compared to the overall market. Thus, the stock is classified as less risky.

Risk Estimation through Beta Ratio

As you know the higher the risk the higher the potential returns.

Betas are often used in order to determine the level of risk a particular stock carries. Thus, a stock with a high beta value implies that the returns of the stock will be greater than the market. Therefore, the higher the level of risk you are willing to accept, the higher the potential rewards you will gain.

On the other hand, a stock that has a beta value of less than 1 generally is safer. However, you should expect lower levels of reward as well.

You can expect young companies, especially technology oriented to carry higher levels of risk and as a result have higher betas.

Beta Drawbacks

No matter how valuable betas may be, you should be careful when using them alone, since they may not provide you with accurate information. This is caused by a number of reasons. The first one is that beta calculations are made on the basis of past information. This means that they may not provide accurate predictions regarding the risk of the investment.

Additionally, beta lacks the consideration of major changes in the industry or sector, which may lead to inaccurate representation of risk levels. Finally, betas measure the volatility of stocks as compared to the whole market. However, this volatility may have a different direction. As a result a stock that is outperforming will have a bet of greater than 1 in a sustained advancing market.

Betas provide their benefits mostly in the short-term, when the movement of the price is of higher importance. Thus, you should consider the beta value if you are about to buy or sell a stock over a short period of time.

In order to make a more reliable evaluation of the risk of a stock you should study the company itself that issues the stock in addition to the beta considerations you make.

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