WHAT IS BETA?
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analysts use the Greek letter beta ( b ) to represent the
measurement of a stock's relative market risk. It measures the degree to which a
stock price fluctuates in relation to the overall market -- otherwise known as
the stock's volatility.
The baseline for this measurement is the overall market, which
has a beta of 1. Any stock with a beta greater than 1 is more volatile than the
overall market. Any stock with a beta less than 1 is less volatile than the
market. Let's look at a hypothetical situation to illustrate this point.
Say a hypothetical Internet company we will call Widget.com has a
beta of 2.0. This means it is two times as volatile as the overall market. Let's
say we expect the market to provide a return on investment of 8 percent. We
would expect Widget.com to return 16 percent. However, if the market declines
and were to provide a return of -5 percent, investors in Widget.com could expect
a loss of 10 percent on their investment.
Conversely, let's say that Local Telecom has a beta of 0.5. This
means that it is half as volatile as the overall market. In our hypothetical
market, then, Local Telecom should have a return on investment of only 4 percent
when the market rises 8 percent, but should only have a negative return of 2.5
percent if the market drops by 5 percent.
Of our two companies, it is clear that Local Telecom is a much
less volatile investment than Widget.com. However, Local Telecom's returns are
also lower when the market has positive returns. This is the fundamental
trade-off between risk and return.
Now that you have an understanding of beta and how it
works, let's look at why beta is important to you.