What is beta in finance and how and how can it help manage risk?

Beta is one of the most widely used risk metrics, designed to show how a security’s share price has behaved relative to the broader market. It can be an important tool in helping to build and maintain a diverse portfolio, capable of withstanding unpredictable market conditions, but cannot be used in isolation.

Beta shows how closely the volatility of an individual stock has followed the pattern of the wider market. It is a backward-looking measure, so has no predictive qualities, but investors can use it as a tool to judge their likely exposure to market movements. If a stock has proved indifferent to market volatility in the past, the hope is that it will continue to do so.

To calculate beta, investors divide the covariance of an individual stock with that of the overall market, and then divide the result by the variance of the market’s return compared to its average return. Covariance measures how two securities move in relation to each other. However, you don’t have to do this yourself - data on the beta of individual stocks is readily available.

A beta in stock of 1 suggests that the stock price would be expected to move in line with the market. A beta of 1.5 would suggest it would move more than the market and a stock with a beta of 0.5 would move less than the market. It is also possible (though rare) to have negative beta, where the stock moves inversely to the market. If an investor wanted a high-risk portfolio, they would target stocks with a high beta, and if they were more risk averse, they would target stocks with a low beta.

It is worth noting that the beta value of stock tells an investor nothing about likely returns. For example, a beta of 1.5 does not imply that if the market goes up 100%, that particular stock will go up 150%. It is only a measure of volatility: if the market is showing volatility of X, the stock has historically shown volatility of X at 1.5x. Equally, volatility measures make no distinction between upside and downside price movements. All investors know from a beta measure is that the stock will move more or less than the market, but not necessarily in which direction.

Beta will vary depending on the index used for measurement, the time period and shifts in market conditions. For example, the volatility of BP might be measured against the volatility of the FTSE 100, while Apple might be measured against the volatility of the S&P 500. Given that beta is measured relative to the index, it tells an investor little about the absolute volatility of an individual stock. If the S&P 500 is highly volatile, a stock with a beta of 0.7 may still be highly volatile, just less so than the index.

Beta only looks at historic performance and therefore does not take into account new information on a company that might make it more or less volatile. For example, a company might take on a lot of debt, or make an acquisition and that could see it become a far riskier investment. It can also be difficult to establish a beta value of stock for investments that are relatively new to the market and have a short trading history.

Beta may also change over time, depending on market conditions. Just as investors are often reminded that ‘past performance is no guide’ to the future performance of a stock, past volatility is not universally reliable when determining future volatility. In theory, it is better to have more beta in a portfolio when markets are rising and less when they are falling, but judging the point in markets to have more beta in a portfolio and when to have less is fiendishly difficult.

That said, beta in stock is a useful proxy for risk and, in combination with other metrics, can give investors a steer on the likely performance of an individual asset. An early-stage biotechnology company, for example, will almost invariably have a higher beta than a staid utility company. It is generally considered more useful as a short-term measure of risk than a long-term measure.

Investors will often see the term beta used in relation to ETFs. The idea is that they provide cheap, liquid access to the performance of the market – low-cost beta. It is the delivery of ‘alpha’ – the return over and above the market – that costs more. The S&P 500 UCITS ETF from Vanguard, for example, has an annual management fee of 0.07% – that’s just £7 on a £10,000 investment. Investors will pay small dealing costs on top, but it is a very cheap way to take exposure to a diversified range of companies.

Increasingly there are a range of so-called ‘smart beta’ options. This is where indices are skewed to overweight a particular part of the market – dividend stocks, for example, or stocks with value characteristics. This will be more expensive than conventional beta, but only by 0.1-0.2%.

Beta is a useful risk metric in judging the likely volatility of an individual stock. It may not tell investors a lot about the potential return, but it can be a helpful tool in portfolio construction and managing risk.

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