Beta, or the beta coefficient, is a number that describes the relationship between an investment's return and the overall market's return. A high beta implies a stock price grows dramatically when the market is up, and falls dramatically when the market goes down. Small values of beta mean the stock's return is relatively unaffected by the swings in the overall market's return.
Because Beta is a comparison to the overall market, a benchmark or baseline representing the overall market is needed. In most cases the S&P 500 is used, although betas can also be calculated against industry-specific indices. Precise methods for calculating Beta can differ.
Beta depends on two factors, multiplied together:
There are several misconceptions about beta. Amongst the most common are:
Because beta is the product of the relative volatility of returns and the correlation of returns, it does allow for some useful conclusions:
Beta is a commonly used tool for evaluating the performance of a fund manager. Beta is used in contrast with Alpha to denote which portion of the fund's returns are a result of simply riding swings in the overall market, and which portion of the funds returns are a result of truly outperforming the market in the long term. For example, it is relatively easy for a fund manager to create a fund that would go up twice as much as the S&P 500 when the S&P rose in value, but go down twice as much as the S&P when the S&P's price fell - but such a fund would be considered to have pure Beta, and no alpha. A fund manager who is producing Alpha would have a fund that outperformed the S&P 500 in both good times and bad.
Beta can also be used to give investors an estimate on a stock's expected returns relative to the market return. Consider some examples:
For individual companies, beta can be estimated using regression analysis (line of best fit) against a stock market index. It is one of the required inputs to the Capital Asset Pricing Model (CAPM), which is used to calculate the expected return of an asset based on its beta and expected market returns. Essentially, to calculate beta for an individual security you take total stock returns for a given period, and simply plot it against the benchmark returns, and then fit a least squares regression line (line of best fit) through the data points. The slope of the line would then be your beta.
The beta for a portfolio of securities is simply the weighted average of each of the individual securities. The weight of each security is the value invested in that security divided by the value of the entire portfolio. A quick example would illustrate the concept. Assume you have $100 invested into two companies for a total investment of $200. The betas for the companies are 1.0 and 2.0 respectively. Therefore, the calculation would be ($100/$200)*1.0 + ($100/$200)*2.0 = 1.5. Therefore, the beta of the portfolio is 1.5.
Values of Beta can vary depending on how they are calculated. Specifically, the main varying components are:
The result of each of these different choices can cause beta values to differ widely depending on how the calculation is made. This means that a beta value is not an exact value of how a stock varies with the market, but a representation.
The beta values on Wikinvest are calculated using total monthly stock returns plotted against monthly S&P 500 (SPX) returns. Wikinvest takes data from the previous three years, or as far back as the stock has data for. Wikinvest then uses a linear regression, or a "line of best fit" to calculate the beta. The exact formula is as follows:
Rs = a + b*(Rm) + e
Wikinvest calculates its portfolio beta by taking a weighted average of all the betas in the portfolio. The weights are determined by taking the value of each security in the portfolio and dividing it by the value of the entire portfolio. Options are not included in this calculation, and cash, bonds, and money market funds are assumed to have a beta of 0. Short positions are calculated the same way, except with a negative weight.