Boring Terms We Need To Know: Beta

Since I've been referencing Beta in my Dividend Income Analysis template I figured it would be a good term to tackle next in my "Boring Terms" series.  I'm a big fan of the motto - not the band - KISS (keep it simple stupid) so I'm not going to weigh you down with the varying formulas, academic theory, and such.  You can look through Beta's Wikipedia page for that.

Typically when someone references the stock term "Beta" they are talking about a specific stock's volatility as it compares to the S&P 500.  There are other variations where you compare a stock's volatility to its Sector Index, International Index, etc...  but we don't care about those.  And when you are looking at a Stock's Beta on Yahoo Finance, they are using the S&P 500.  So let's get to the details and why we care about it.

The market (S&P 500) always has a Beta = 1.  So a beta of 1 indicates that the stock's price will move with the market. A beta of less than 1 means that the stock will be less volatile than the market. A beta of greater than 1 indicates that the stock's price will be more volatile than the market.  Higher-beta stocks tend to be more volatile and therefore riskier, but provide the potential for higher returns (or bigger losses). Lower-beta stocks pose less risk but generally offer lower returns (or less losses).

Here are examples of each:

Average Beta: (1.0)
If the market goes up 10% in a year and our stock goes up 10% in a year, our stock will have a Beta = 1.0.  If the market goes down 10% in a year and our stock goes down 10% in a year, our stock again has a Beta = 1.0.

High Beta:( > 1.0)
A stock with a beta of 2 has returns that change, on average, by twice the magnitude of the overall market's returns; when the market's return falls or rises by 3%, the stock's return will fall or rise (respectively) by 6% on average.

Low Beta: ( < 1.0)
A stock with a beta of 0.5 has returns that change, on average, by half the magnitude of the overall market's returns; when the market's return falls or rises by 6%, the stock's return will fall or rise (respectively) by 3% on average.

Why do we care about Beta when analyzing a stock for dividend income?  Because as we are collecting our dividend income each quarter, we don't want to worry about wild price movements in the stock that could have adverse affects on our principal investment.  We want a lower beta stock (< 1) because this signifies that the stock is less risky and less volatile as compared to the market.

That's it, pretty easy right?  And its a figure that is very easy to find on a stock quote as well so you don't have to worry about doing the math.

Related Posts: Boring Terms We Need to Know