The Beta is calculated in the CAPM model (Capital Asset Pricing Model) for calculating the rate of return of a stock or portfolio. Essentially, beta expresses the trade-off between minimizing risk and maximizing return. On the other hand, if the market declines 6%, investors in that company can expect a loss of 12%. Beta can play a big role in portfolio construction and volatility expectations.

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Advances in machine learning and artificial intelligence may lead to new methods for estimating and interpreting these coefficients, particularly in complex models with numerous predictors. While beta coefficients are powerful tools for understanding relationships between variables, they come with limitations. For instance, they assume a linear relationship between the independent and dependent variables, which may not always hold true. Additionally, beta coefficients can be influenced by multicollinearity, where independent variables are highly correlated, potentially distorting the results. Analysts must be aware of these limitations and consider alternative methods or transformations when necessary.

Using Beta to Understand a Stock’s Risk

If a stock moves less than the market, the stock’s beta is less than 1.0. Beta (β) is the second letter of the Greek alphabet used to measure the volatility of a security or portfolio compared to the S&P 500 corda crypto price which has a beta of 1.0. A Beta of 1.0 shows that a stock has been as volatile as the broader market.

Relationship between own risk and beta risk

Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. A negative beta is when an asset moves in the opposite direction of the stock market. Stocks that have a low beta, such as consumer staples, are often used to hedge a portfolio of higher-beta stocks.

A gold exchange-traded fund (ETF), such as the SPDR Gold Shares (GLD), is tied to the performance of gold bullion. Consequently, a gold ETF would have a low beta and R-squared relationship with the S&P 500. While systematic risk inherent to the market play the long game when learning to code has a meaningful impact in explaining asset returns, it ignores the unsystematic risk factors that are specific to the firm. Eugene Fama and Kenneth French added a size factor and value factor to the CAPM, using firm-specific fundamentals to better describe stock returns. Note that beta can also be calculated by running a linear regression on a stock’s returns compared to the market using the capital asset pricing model (CAPM).

• Beta coefficients are calculated during the process of fitting a regression model to a dataset.
• These low-beta stocks are relatively unaffected by the market’s gyrations or even benefit in times when the economy is poor.
• However, as we continue adding more to the portfolio, the portfolio’s returns will gradually start more closely resembling the overall market’s returns.
• In this case, Stock OW has a positive alpha because the investor earned more than the projected investment risk.
• The beta coefficient is a financial metric that measures the volatility of a stock with relation to the broader market, which implies the benchmark index of the United States stock market – the S&P 500.

Beta is used in the capital asset pricing model (CAPM), a widely used method for pricing risky securities and for generating estimates of the expected returns of assets, particularly stocks. The CAPM formula uses the total average market return and the beta value of the stock to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. In this way, beta can impact a stock’s expected rate of return and share valuation.

Negative Beta Value

It also assumes a linear relationship between a stock’s and overall market returns. The beta formula presupposes homoscedasticity, where the variability of stock returns is constant over time. Beta is used in the formulae of the capital asset pricing model (CAPM), which calculates the expected return of an asset based on the value of beta and expects a market return. It can show the relationship between a hedge fund’s returns and the market return. Beta can show how much risk the fund is taking in certain asset classes and can be used to measure against other benchmarks, such as fixed income or even hedge fund indexes. This measure can help investors determine how much capital to allocate to a hedge fund or whether they would be better off keeping their exposure in the equity market or even cash.

Below is the beta formula, which breaks down how both covariance and variance are computed. Assume that the beta of an investor’s portfolio is 2.0 in relation to a broad market index, such as the S&P 500. If the market increases by 2%, then the portfolio will generally increase by 4%. If the market decreases by 2%, the portfolio generally decreases by 4%. Not surprisingly, there are exchange-traded funds that concentrate on low-beta choices.

For example, beta does little to predict what a stock will do if it faces industry headwinds. It also doesn’t predict how stocks will react to their own news, such as earnings reports. Levered beta includes both business risk and the risk that comes from taking on debt. However, since different firms have different capital structures, unlevered beta is calculated to remove additional risk from debt in order to view pure business risk. The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued. The beta (β) of an investment security (i.e., a stock) is a measurement of its volatility of returns relative to the entire market.

In this case, Company XYZ is considered less risky than the market NASDAQ with its beta of 0.817. In this article, we delve into the concept of Beta Coefficient, explaining its significance in finance, providing practical examples, and highlighting its role in investment analysis. To use this regression function, select Data analysis from the Data Tab of your Excel Worksheet. For example, as of Oct. 27, 2020, the beta for Microsoft (MSFT), as found on Yahoo! Finance, is 0.92. Get bitcoin and cryptocurrencies 2021 stock recommendations, portfolio guidance, and more from The Motley Fool’s premium services. There is a lot of hope baked into its share price, resulting in wild swings whenever it fails/exceeds expectations and a five-year beta of 2.41, as of June 2024.