How should investors assess risk in the stocks that they buy or sell? While the concept of risk is hard to factor in stock analysis and valuation, one of the most popular indicators is a statistical measure called beta. Analysts use it often when they want to determine a stock’s risk profile. However, while beta does say something about price risk, it has its limits for investors looking to determine fundamental risk factors.

## What Is Beta?

Beta is a measure of a stock’s volatility in relation to the overall market. By definition, the market, such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.

A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High-beta stocks are supposed to be riskier but provide higher return potential; low-beta stocks pose less risk but also lower returns.

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Key Takeaways

- Beta is a concept that measures the expected move in a stock relative to movements in the overall market.
- A beta greater than 1.0 suggests that the stock is more volatile than the broader market, and a beta less than 1.0 indicates a stock with lower volatility.
- Beta is a component of the Capital Asset Pricing Model, which calculates the cost of equity funding and can help determine the rate of return to expect relative to perceived risk.
- Critics argue that beta does not give enough information about the fundamentals of a company and is of limited value when making stock selections.
- Beta is probably a better indicator of short-term rather than long-term risk.

Beta is a component of the capital asset pricing model (CAPM), which is used to calculate the cost of equity funding. The CAPM formula uses the total average market return and the beta value of the stock to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. In this way, beta can impact a stock’s expected rate of return and share valuation.

## Calculating Beta

Beta is calculated using regression analysis. Numerically, it represents the tendency for a security’s returns to respond to swings in the market. The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period.

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