Why You Should Add Beta to Your Investment Toolkit

You shouldn't overlook a stock's volatility relative to the market when making investment decisions, since volatility can affect your portfolio's risk level and its potential returns. An important and readily available measure of a stock's volatility is beta. Here are some reasons you should add beta to your investment toolkit.

Beta is a measure of risk. It indicates how much a stock's price has fluctuated in the past relative to movements in the overall stock market.

Beta is easy to understand. Despite the term beta, which sounds like a complex mathematical concept, what beta measures and how it is presented (in a single number) are fairly straightforward. If a stock's beta is 1, its price has, in the past, moved up or down in line with changes in the stock market's value. A beta above 1 indicates a stock's price tends to move more than the market in either direction, up or down, and a beta below 1 indicates that a stock's price tends to move less than the market, either up or down. The higher or lower the beta, the greater the disparity in price movement relative to the market. For example, a stock with a beta of 4 has, historically, been more volatile relative to the market than a stock with a beta of 2.

Beta is easy to find. Many financial websites that provide statistics on individual stocks, such as Yahoo's Finance site, include beta in their databases.

Beta can help you compare the expected volatility of two or more stocks.

Beta can help you manage risk in your portfolio. How you use beta depends, in part, on your risk tolerance and view of the outlook for the stock market. For example, if you are risk averse and/or believe that the stock market is likely to fall (but still want to have some money invested in stocks), you could look for stocks with betas below 1. By filling your portfolio with low-beta stocks, you will give up some upside potential if the stock market rises, but you may sleep better at night knowing that your portfolio shouldn't suffer as much if the market falls. If, on the other hand, you are willing to take more risk and/or expect the market to rise, you could seek out higher-beta stocks.

While beta can be a very useful investment tool, it also has some disadvantages.

A stock's beta is a historical measure , since it is determined by how the stock's price has moved in the past relative to movements in the stock market. There is no certainty that its share price will continue to act in the same way relative to the market in the future.

A stock's beta may (and probably will) change over time. For example, the shares of an immature, small-capitalization technology company whose prospects are dependent on developing and successfully marketing cutting-edge products might have a very high beta; as this company matures and becomes a larger, established firm with more stable and predictable financial results, its beta may fall.

Beta is a measure of only one type of risk. It is not an indicator of other types of risk that can affect a stock's performance, including company-specific and industry-specific risks.

While beta is a valuable statistic for investors, it is only one tool to help you make investment decisions. Use it in conjunction with other equity analysis tools, including fundamental research.

Sources:

Ben McClure, http://www.investopedia.com/articles/stocks/04/113004.asp , Beta: Know The Risk

http://www.investopedia.com/articles/01/102401.asp , Beta: Gauging Price Fluctuations

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