Trillionaire Term of the Day - February 6, 2009 - Beta

Beta

Beta is a measure of the amount of correlation between a stock and the overall financial markets. The number provides an understanding of the performance of a specific security in comparison to the movement of an entire market. The benchmark for markets, the S&P 500, is the most common choice for calculating beta.

Stocks with positive betas follow the movements of the market. If the market improves the stock will rise. If the market falls the stock will decrease in value. Stocks with negative betas move inversely when compared to the market. If the market goes up, the stock loses value, and vice versa.

The exact numerical value of beta is important to understand as well, because it allows us to interpret the volatility of a stock compared to the market. Because the number is calculated by comparing a stock to the market, the market has an unchanging beta of 1. If the beta of a stock is less than 1 it is less volatile than the general market. If the beta of a stock is greater than 1 it is more volatile than the market.

A stock with a beta of 2 will rise when the market rises, but twice as much. A stock that has a beta of -2 will gain as the market declines at double the rate. Let’s compare the betas of previous Trillionaire Stocks of the Day, WuXi PharmaTech (WX) and The Coca-Cola Company (KO), to understand the use of beta.

WuXi is a speculative stock: it has a very low market capitalization of 397M and hasn’t been around for a long time. Its beta is 2.3. If the market were to increase by 3%, then WX should increase by 6.9% (2.3 X 3). Coke is a stable blue chip stock: it has a very high market cap of 100B and is an established company. KO has a beta of .63. If the market were to increase by 3%, Coke would increase by 1.89% (.63 X 3).

Stocks with higher positive betas or lower negative betas are volatile. So we would consider WX to be a volatile stock, as it exaggerates the movements of the market, up or down. KO is less volatile than the general market, and it increases less than the market increases and decreases less than the market decreases.

A stock with a high beta can provide higher returns, but also bigger losses. So when you buy a stock with a greater beta you take on more risk with the intention of larger profits. A stock with a low beta will provide smaller returns and lesser losses. Buying stocks with lower betas can help you add more stability to your portfolio and allow you to invest defensively.

 

-Matt Schwartz

College Trillionaire