What Is a Stock’s Beta? What to Know About Stock Volatility and Risk

John Mlekoday is a senior investment consultant with the Northwestern Mutual Wealth Management Company.  

If you look at a chart of the S&P 500’s performance over the past 50 years, you’d probably notice a few things. 

First, you’d notice that it’s a lot higher today than it was 50 years ago—evidence that investing in equities can be an excellent way to grow your wealth over time. Second, you’d notice that your growth didn’t happen in a straight line. The market was and still is a volatile beast, experiencing swings both up and down.  

While volatility is a natural part of investing, that doesn’t mean there aren’t ways you can manage it in your portfolio. One way you might limit the volatility of your portfolio, for example, is by diversifying across multiple assets and asset classes, depending on your risk tolerance and investment timeline. Another is by evaluating the volatility of any potential investment before you add it to your portfolio by calculating its beta. 

Below, we take a closer look at what beta is in investing, how it’s calculated and how it can help you design and manage a portfolio to meet your personal goals. 

What is beta in finance? 

In investing, beta (β) measures how much risk and volatility an investment (stock, fund, portfolio, etc.) has compared to the broader market as a whole.  

Think of it like this: There are certain market forces—inflation, interest rates, unemployment figures, etc.—that tend to have an impact on all investments, leading to what is known as systematic risk. But when these forces exert pressure on the market, individual investments will react to this pressure in their own ways. Some investments will feel the forces more, resulting in larger moves compared to the overall market. Others will feel the forces less, resulting in smaller swings. And others still will feel the forces at exactly the same rate as the market. 

Beta measures how differently an individual investment will react to systematic risk compared to the broad market. It gives investors insight into how volatile—and therefore how risky—a particular investment might be.  

Beta vs. alpha vs. “the Greeks” 

The term “beta” comes from the second letter of the Greek alphabet. And beta isn’t the only financial term that investors use that originates from the Greek alphabet. Others include: 

• Alpha, which seeks to measure how much additional return an investment might offer compared to the overall market. 

• The Greeks, which is a suite of variables (including delta, theta, gamma, vega, rho and more) that seek to quantify risks involved in options trading.  

How a stock’s beta is calculated 

Calculating a stock’s beta involves some pretty complicated math that most investors probably won’t want to do on their own. The good news is this: You can readily find a stock’s beta on many online quoting tools and brokerages. 

If you still want to know how beta is calculated, it’s guided by this formula: 

Beta (β) = Covariance (Re, Rm) / Variance (Rm)  

Simply put, covariance is a math function that quantifies changes in one thing with respect to something else. Here, it looks at the returns of one stock (Re) compared against the returns of the market as a whole (Rm). Variance quantifies how far apart a set of data points are from each other and their average.   

How to interpret a stock’s beta 

To interpret the beta of an individual stock, fund or your portfolio as a whole, it’s important to first understand that the overall market has a beta of one. All other betas are understood in relation to the market’s baseline beta. 

A beta equal to 1 

When an investment has a beta that is equal to or close to one, that means that it moves in line with the market. If the market goes up or down by 5 percent, for example, the investment is likely to follow suit. Adding an investment with a beta equal to one to your portfolio is unlikely to increase the overall volatility or risk of your portfolio—but because risk and return are correlated, it’s also unlikely to facilitate outsized returns compared to an investment that simply tracks the market (like an index fund).

A beta greater than 1 

When an investment has a beta greater than one, that means that it feels market forces more strongly, and experiences greater volatility than its benchmark. A stock with a beta of two, for example, will move twice as much as the underlying market. If the market decreases by 10 percent, that means the individual stock is likely to decrease by 20 percent. While there is technically no limit to how high an investment’s beta can be, it’s rare to see one above a three. 

Incorporating a high-beta investment into your portfolio will increase its overall volatility but also offers the potential for outsized returns compared to the broader market. Certain industries, like the tech and biotech industries, are home to a large concentration of high- beta stocks because those industries tend to react to changing economic cycles with greater volatility.  

A beta less than 1 

An investment with a beta that is less than one will see a more muted reaction to market forces compared to the broad market. An investment with a beta of 0.5, for example, will move about half as much as the market when these forces change. If the market sees a gain of 5 percent, for example, the investment on its own would likely see a gain of only 2.5 percent; conversely, if the market decreased by 5 percent, the investment’s value would likely decrease by only 2.5 percent. 

Including low-beta investments in your portfolio can provide something of a stabilizing force for your portfolio, reducing its overall risk and volatility. The trade-off, of course, is that this stability comes with a lower potential for returns. Industries that tend to perform the same regardless of the underlying economic cycle—like utilities and consumer staples—tend to have a lower beta than other industries.  

A negative beta 

A negative beta is rare but not unheard of. When an investment’s beta is negative, it means that it is negatively correlated with the market. When the market goes up, the negative-beta investment goes down; when the market goes down, the negative-beta investment goes up.  

Holding negative-beta investments can help you hedge some of the downside risk of your portfolio, especially against serious market downturns. They also provide diversification, that golden rule of investing. Gold, precious metals and the companies that mine for them will often have negative betas, as will certain options and derivatives that gain value when the market decreases. 

Drawbacks of using beta 

While beta can be a powerful tool, it’s important to understand its limitations so that you don’t rely too heavily on a single point of data. Here are some key facts you want to keep in mind when using a stock’s beta to make investment decisions: 

Beta is backward-looking 

Calculating the beta of an investment requires you to consider historical data about that asset’s performance—typically, 36 or 60 months' worth of data. While this gives you insight into how an asset has already performed, it cannot predict or guarantee future performance.  

It works only for established companies 

Because you need so much historical data to calculate a stock’s beta, it really isn’t possible to find the beta of a young company—like one that has recently started selling stock.  

It lacks context 

While beta helps you calculate how volatile an investment has been, it doesn’t offer any insight into the why of that performance.  
 
Instead of relying entirely on beta when making investment decisions, you’ll typically want to consider a variety of metrics, like a company’s profitability ratios, leverage ratios and more.  

How to use beta to build your portfolio 

If you’re building and managing your own portfolio from scratch, knowing the beta of each investment you’re considering will allow you to understand how much risk and volatility it might introduce to your portfolio. This added context will help you allocate your holdings across and within multiple asset classes depending on your investment goals, timeline and risk tolerance.  

Investors who are saving for long-term goals and who don’t anticipate needing their money for years or decades, for example, might find high-beta investments more attractive due to the possibility of higher returns that they offer. Meanwhile, investors who are in or nearing retirement—and who therefore might not be able to stomach wild swings in portfolio value—might choose to focus on lower-beta investments for more stability.  

As with any financial tool, it’s important to not rely solely on a stock’s beta when making decisions. Keeping your whole financial plan in view will ensure that you’re making decisions that will benefit your long-term goals.  

More importantly, you don’t have to build a portfolio or financial plan alone. Your financial advisor can ask the right questions to help you identify what’s most important to you and then build a plan that uses investments for growth and additional financial options to help protect you and your family. Looking at your financial picture more broadly can help to ensure all the individual pieces are working together to support your goals in life.