Investing Series: What does beta mean?

This is a part of the Investing Series.

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Beta is something that finance people throw around to look smart, but believe it or not, it has an actual meaning.

It doesn’t just come after Alpha, or mean a colourful, fighting fish, it simply means how volatile a stock is in relation to the stock market itself as a whole.

 (This fish is NOT what they’re referring to when they say “beta” in finance)

VOLATILE? WHAT DOES THAT MEAN “VOLATILE”?

Keep in mind as you read, that a beta benchmark is 0 (zero).

“Volatile” refers to how a stock behaves in contrast to the stock market as a whole.

It means how in-tune a stock is with the overall stock market, as in how dependent it is on let’s say financial news such as daily rants from analysts trying to influence investors like a herd of bleating sheep.

So take for instance Research in Motion (BBRY) a “hot” stock that has seen a lot of buying and selling over the first half of 2013. Research in Motion has a high beta because it’s REALLY influenced by articles analysts write, the news, the media and constant reporting on how it is doing.

If we take a look at Research in Motion’s beta for May 28th 2013, it says: 1.70

This high beta of 1.70 above a beta of 1, tells investors that it’s a stock that relies heavily on how the stock market behaves.

A QUICK CHART ON BETA VALUES & THEIR MEANINGS

The benchmark for talking about beta is 0, so that’s where I’ll start.

Also, I’m saying “stocks” but I am talking about anything that’s traded on the stock market, including bonds for instance.

• Beta = – 0 – This means the stock moves the other direction of the stock market
• Beta = 0 – This means steady, boring, plodding along, something like bonds
• Beta = 0.01 – 0.99 – This means the stock moves along with the stock market
• Beta = 1 – This means the stock moves exactly along with the stock market
• Beta = 1+ – This means the stock is REALLY sensitive to the stock market

This can get kind of confusing so let’s go into some examples.

WHAT DOES IT MEAN IF….

BETA = LESS THAN 0

• When the stock market does well, this stock tanks.
• When the stock market goes down, this stock goes up.

Example: Gold

Remember gold during the recession? It shot up in value like gangbusters because the economy and overall stock market was tanking, so everyone rushed to the one “safe” investment of gold.

(By the way it is absolutely not true that gold is “safe” as an investment by any means because it’s just another commodity if you think about it, but that’s another post for another day.)

Ahem.

Anyway, everyone rushed to invest in gold because the stock market tanked, which is what made its prices shoot sky high.

When gold starts to drop in value, it’s usually an indication that the overall stock market is improving.

BETA = 0

• Steady, unruffled, unconcerned investment
• Doesn’t care about what’s happening in the market
• Does it’s own thing regardless of what’s burning up or down

Example: Bonds

If you buy bonds, you are guaranteed whatever they said they would pay you in interest for buying bonds, regardless of what happens on the stock market.

Bonds are the perfect example of the “I don’t care, my beta is 0” group.

BETA = 0.01 – 0.99

• Somewhat affected by what’s happening on the stock market
• Doesn’t move in perfect synchrony with the stock market (unless you’re close to 0.99)
• The lower range of this means it is more steady and LESS volatile
• The higher range of this means it is LESS steady and more volatile

Example: A lot of stocks fall into this group such as consumer staples, utilities..

Think of consumer staples or food — you have to use electricity and water, and buy shampoo regardless of what happens right?

Well stocks that deal in things like consumer staples are affected by the stock market’s movements, but depending on how high their beta is, they may not be as sensitive to what happens.

Take for instance Procter & Gamble, an excellent example of a consumer staples company that deals in everything from shampoo to soap:

Check out that beta! 0.48, meaning it’s somewhat sensitive to the stock market going up or down as a whole, but since it’s in consumer staples, they know they’re still going to sell soap to people even if the stock market really tanks.

They just might sell less soap, but they’re at least going to sell soap over a new MP3 player or fancy cellphone.

BETA = 1

• Moves exactly along with the stock market
• Probably is one of the major stocks that is traded on the stock market that influences it
• Is considered fairly risky and is the benchmark number for the beginning of “volatility”

Example: Apple

I hate to keep bringing Apple up as examples in my series but they’re just so perfect…

Anyway, they have a beta of exactly ONE, which tells me that they’re one of the movers and shakers of the markets, which stands to reason seeing as stock markets move because of stocks, and this happens to be one of the big kahunas that make it go up or down.

If the market goes up, they go up too. If it goes down, they tank along with it.

I should mention that because it’s beta = 1, it not only means that it influences the stock market movement, but it also means it’s a fairly risky stock.

Betas that equal 1, are risky. Any higher than 1, and you’re looking at UBER volatile stocks like Blackberry in the example above, which brings me to….

BETA = 1+

• Extremely risky. 1 is the threshold of “max riskiness”.
• It’s REALLY sensitive to the movements of the stock market, any piece of news could send it plummeting down, or shooting sky high.
• Possibility for high gains.

Example: Research in Motion (and almost any high-tech company out there, or even companies like General Electric (GE))

A beta of more than one means that the stock reacts like gangbusters to any little blip.

If you have been following the Research in Motion saga as I have from the start of 2013, every time an analyst makes a YAY or NAY call on the stock, it dips in response.

You don’t really see that with stocks that have lower betas because people pooh-pooh such news, but when you get into the higher beta leagues, people start fainting and freaking out at the slightest tremors.

All of this sounds extremely nerve-wracking, but it’s also exciting because there is a possibility of big money to be made.

USE BETA TO QUICKLY EVALUATE STOCKS

When you look at the beta, it tells you immediately if the stock is close to acting like gold (less than 0), bonds (0), acting like shampoo (0.50), or acting like a high-tech company (1.7).

It is not the be-all and end-all but it’s a handy indicator to understand where the stock lies in terms of the great big financial picture.

That way, you know how risky or volatile a stock is, and you also know what you’re getting into when you think about having to wake up at 6 a.m. in the morning with heart palpitations because you dreamed that your stock picks tanked…

SO WHY DON’T WE JUST INVEST IN STOCKS WITH A LOW BETA?

If waking up in a cold sweat over your stock portfolio gives you the hives, you might be inclined to just invest in stocks with a very low beta.

Well my friend, therein lies the rub.

Risk = Reward

The more risk you take, the more money you make. The less risk you take, the less you make.

Heck you might even LOSE money if you invest in stocks that don’t really do anything or make any money, because you lose about 3% to inflation each year.

SUMMARY

• Beta refers to the volatility or risk of a stock in relation to the entire stock market
• A beta benchmark is 0 (e.g. bonds) and the riskiest stocks start with a beta of 1
• Anything below a 0 means it moves in the opposite direction (e.g. gold)
• Stocks that have a beta of 1 mean that they’re big-time influencers on the market