Beta is a rough measure of risk you can use when you are choosing investments to help you decide how an investment might fit into your portfolio. Here are some things you should know about beta.
By definition, the price swings in the stock market are equal to 1. The market, as random and volatile as it is, is used as the baseline for measuring beta.
The beta of any given investment (stock, mutual fund, ETF, REIT) is a number, typically close to 1. A low beta stock is a stock with a beta of less than 1. A high beta stock would be a stock with a beta greater than 1.
High Beta Stocks
Investments with a beta greater than 1 are expected to swing in the same direction as the market, but to a greater degree. When the stock market is moving up, high beta stocks would be expected to rise even faster than the broad market. When the market falls, these stocks are expected to fall even faster.
Low Beta Stocks
Investments with a beta lower than 1 are expected to swing in the same direction as the market but less dramatically.
As you look at building a strong portfolio, one of the things to consider is the beta of each of your investments. If all of the investments have a high beta, you'll be whistling a happy tune every time you look at your financial statements-so long as the market is moving up. When it turns down, your tune will likely change. Building a portfolio with some high beta and some low beta stocks would generally be considered wise.
Just like stocks, mutual funds have a beta measurement. A mutual fund full of high beta stocks will generally have a lower beta than the individual stocks as their collective movement will be dampened a bit. If you are building your investment portfolio largely with mutual funds, you may wish to get your high-beta investment via a mutual fund rather than with individual stocks.
Beta is a historical measure and is only meaningful to the extent that the future is like the past. A new CEO, a new product line, a strategic acquisition, or a large recall are just a few examples of events that might cause a company's stock price movements to change. Beta is only one tool in your toolbox for measuring risk and performance. Be careful not to focus solely on this one measure.
Beta gives investors a shorthand way to measure and discuss the risk and expected returns of a particular investment. By knowing the beta of each investment in your portfolio-being sure to update that from time to time-gives you another way to analyze and build your investment strategy.