Investing can be a lot like jumping on a trampoline. One minute you're up; the next you're down. The whole experience can be downright exhausting. Wouldn't it be great if you could anticipate just how much bouncing a stock would do before you purchased it?
It turns out you can – at least theoretically – thanks to a statistical measurement known as beta.
What is beta?
When you hear "beta" in reference to investing, think "broad" or "benchmark." Beta is a measure of how volatile an investment's price is relative to the broader market or a benchmark such as the S&P 500.
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It's measured on a numerical scale where a beta of one indicates the security's price moves in line with the market benchmark. A beta of less than one indicates the security is less volatile than the market benchmark. A beta greater than one suggests it's more volatile than the market benchmark.
So, if you invest in a security with a beta of 1.0, you're getting pure market exposure. "There are no adjustments for market conditions or changes," says Mike Thompson, a chartered financial analyst and co-portfolio manager at Little Harbor Advisors. "You get exactly what the market delivers in good times and bad times."
Sometimes this is all you want. But other times, he says it can be helpful to offset some of that with tactical management.
How to use beta in investing
You can use beta to help align your portfolio with your risk tolerance, says Tim Urbanowicz, head of research and strategy at Innovator ETFs.
If you know your stomach does somersaults anytime your portfolio's value drops, you may want to invest in more lower beta securities. This tactic will help reduce the downswings but may also mean your portfolio doesn't rise as high during up markets because beta goes both ways.
A stock with a beta of 0.5 is half as volatile as the broader market. If the market goes down by 10%, the stock should only decline by 5%. But if the market goes up by 10%, the stock should only go up by 5%. Meanwhile, a stock with a beta of 2 will double the broader market's returns, both up and down.
You should be aware of where beta is concentrated in your portfolio, "whether it is spread across the portfolio and how the portfolio aligns," Thompson says.
Final notes on beta
The challenge with using beta in investing is that beta is a historical measure, Urbanowicz says. "Assets that were once low beta may not be low beta moving forward."
Beta is a backward-looking measure. It's "one measurement of risk based on the behavior of the market as a whole or to a benchmark's return stream, but that doesn't mean it's always going to do what's expected," Thompson says.
Beta is also only a measure of market risk. It can help you determine how a stock will react to events that impact the market as a whole. It doesn't tell you anything about the company-specific risks the stock may face, which is one reason you shouldn't rely solely on beta when making investing decisions.
It's also important to remember that beta is a measure of volatility, and volatility is only one type of risk. Even low-beta stocks can incur large losses – they just shouldn't be as large as those experienced by the market as a whole.
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