What is Beta?

Beta is a systematic risk measurement which quantifies the correlation of a security or portfolio to a benchmark index such as the S&P 500 or Dow Jones Industrial Average.  A positive beta will indicate that the stock or portfolio should follow the market up or down while a negative beta will indicate the opposite meaning the stock will generally move in the opposite direction of the market.

It is calculated through regression analysis and gives the trader an indication of what to expect based on how the benchmark index performs.  For example, a portfolio with a beta of 2 tells us that the portfolio will incur a movement equal to two times that of the broad market.  Generally speaking, the more positive or negative a beta is, the more volatility that is experienced when the market moves up or down.  Stocks with a beta far greater than 1 or less than -1 may indicate greater business risk and lower quality of earnings.  

Investors should be careful correlating beta with investment attractiveness.  Remember, beta is a measurement of correlation between the portfolio or security against an index; it does not define the investment return.  This is particularily true for beta's that reside closer to 0.  For example, a certain stock may have a very low beta but may perform 3 times as well as the benchmark.  This low beta just indicates that one cannot expect a strong move up in the broad market benchmark to correspond to a strong move up in this stock.  Conversely, the stock may be up 8% when the broad market index is flat for the day.

Beta is a key component of the capital asset pricing model and enables us to predict the expected return on equity as a function of leverage and security risk.  For example, let's assume a situation where the market was up 10% on the year and let's also assume that two portfolio managers were up 25% on the year.  The first manager had a portfolio beta of 2 while the second had a portfolio beta of 3.  What does this tell you?  It tells you that the second manager took far greater risk and used more leverage and did not exceed the returns of a manager that took far less risk.  The lower beta implies a higher alpha for the first portfolio manager while the second manager actually yielded a negative alpha. 
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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