Beta is a useful measure to determine how wildly one stock, fund, or other security will move with movements in a stock market index. To calculate beta, the price action of a single stock or fund is compared to the price action in the S&P 500 index.
Beta can range from negative to positive infinity. Here’s what beta means at various intervals:
- Negative – A negative beta score implies that a stock or fund will move opposite of the market. If you see negative beta, know that the security will move down when the market is up, and up when the market is down. A short position on the S&P 500 index would have a negative beta score of 1.
- Zero – Zero beta implies no correlation, positive or negative, between a stock and the S&P 500 index. The movements are not at all correlated. (Hedge funds traditionally try to create profitable funds with zero beta, or zero correlation to the market at large.)
- Positive – A positive beta score means that the stock or fund will move with the S&P 500 index. If the S&P index is up, expect for anything with a positive beta to be up. A beta of 1 matches the S&P 500 index movements – the SPY ETF (an ETF that tracks the S&P 500 index) is one of the rare funds that manages a perfect score of 1.
How to Use Beta in Your Portfolio
Beta can be used to create a balanced portfolio. When investment professionals talk about risk, they are usually talking about beta, or how much a portfolio will rise or fall with the broad market. A fund with a beta of 0.5 would be less “risky” than a fund with a beta of 2. You can expect much more volatility in a fund with a higher beta than a fund with a lower beta.
Here’s how you might use beta in your own portfolio:
- Reduce Volatility – You can reduce volatility with low-beta securities like bonds. Bonds typically do not trade with any relationship to the stock market. For example, Google Finance lists the beta of the Vanguard Total Bond Index ETF (BND) at 0.02. At nearly zero, this bond fund moves with no real relationship to the S&P 500 index. Adding it to a portfolio with the S&P 500 index would give you positive yields from bond payments while reducing your exposure to the movements of the stock market.
- Increase Leverage – You can use high beta stocks and funds to increase the relationship between your portfolio and the stock market. For example, the small cap Russell 2000 Index ETF (IWM) by iShares has a beta of 1.2. This means that the fund will trade up or down with bigger movements than the S&P 500 index. When the broad stock market is up, you can expect this fund to beat the S&P 500 index as far as total returns go. However, when the S&P 500 index is down, you can expect this fund to lose more value than an S&P 500 index fund.
Have you looked at your portfolio’s beta?
About JT McGee
I often look at a portfolio’s or a fund’s beta. As you mentioned it’s a great way to tell how wildly it will swing in accordance to the market fluctuations.
Absolutely. I think it’s a lot more important for shorter-term investments/trades, but either way, it is valuable for knowing how strongly correlated the portfolio, stock or fund is with the broad market.
Sounds like a good way to guage your portfolio’s balance. If you want completely balanced, just end up at 0, right?
In an ideal world, a beta of zero with decent returns would be superb. It’s almost impossible to find or build a portfolio like that for retail investors. One example might be Prosper, where your returns are completely non-market correlated so long as you hold each note to maturity.
When I read about Beta, I wonder about just buying and holding the highest Beta stocks on earth for the long run. In theory, since the general direction for equities is up over time, you’d think that would outperform! But I haven’t seen that play out per se. A very simple test would be just looking at Nasdaq vs. Dow or SPY over time. Even though QQQ is certainly more volatile, over decades long periods, it’s not necessarily a hands-down winner.
Interesting… Similar to Darwin, wouldn’t a higher Beta then be better in the long run since we assume the market will continue to rise over time?
Why worry about beta when I’m generating alpha all day?