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Beta in Stock Market

Beta in the stock market is used by stock investors to help identify opportunities in a market that is trending up. Beta in stock market also helps to identify lower risk stocks during a bear market. Think of beta in the stock market as the tendency of the stock to move up or down relative to the overall movement of the index, in this case the S&P 500.

Stock Market Beta Definition

The stock market beta definition is a measure of the expected movement of the stock relative to a related stock index such as the S&P 500. A beta of 1.0 indicates the movement of the stock will tend to mirror the movement of the index, the S&P 500. If your stock has a beta of 1.4, it will move on average 1.4 times the S&P 500. The higher the beta, the more volatile the stock relative to the market index.

Normally, it is good to own high-beta stocks when the market is trending up. You want to own stocks that are more likely to rise faster then the overall stock market.

It is bad to own a high-beta stock during a bear market. You do not want to own stocks that will fall more than the stock market.

A stock beta of 0.80 indicates the stock price will move approximately at 80% of the movement of the S&P 500, the index. When the market is trending down, owning low-beta stocks can be a good way to reduce your risk, though the stock can still lose value.

According to asset pricing theory, beta is the type of risk (systematic) that cannot be reduced through a diversified portfolio. This means when the market falls your stock will fall, as well. However, it will tend to fall in proportion to its beta.

According to Campbell Harvey, at Duke University, you should be aware of several issues when using beta in stock market:

  1. The beta of a stock in the market can change over time due to the rate of return of the stock and the rate of return of the index, the S&P 500 for our case.
  2. Betas can vary depending on the trend of the market. Often betas increase in a down market, as the rate of return on the stock changes faster than the rate of return for the overall market.
  3. A lightly traded stock may have a biased beta.
  4. The beta of a stock is not a complete measure of risk.

Investors use the beta of a stock in the market to help them identify the stocks that are likely to outperform the market. When the market is trending up, stocks with a beta greater than 1.0 should outperform the market.

On the other hand when the market is trending down, investors are better off with stock betas less than 1.0, as they will not fall as fast as the market.

Calculate Stock Beta

Most widely used financial sites such as Yahoo!Finance provide the beta for each stock, eliminating the need for you to calculate stock beta.

For those who wish to know how to calculate stock beta, here is the formula:

Beta = (Covariance (r, Km))/(Standard Deviation (Km))2

where

r is the rate of return of the investment
Km is the rate of return of the asset class, in this case the S&P 500.

By the way, beta can apply to any asset and asset class where you can find the rate of return on the asset and the asset class.

Summary

Beta in the stock market provides investors a quick way to measure the relative return of a stock compared to a stock index such as the S&P 500. Fortunately, many financial sites provide the beta of each stock, so you do not have to calculate stock beta.

At Trading Online Markets LLC, we use beta to help identify those stocks that might offer higher returns should the market trend up as one way to help us bear the stock market.


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