Most stock market investors want to maximize their potential for profit, while minimizing their exposure to financial risk. Beta is a statistical measure that allows investors to assess the probability of a stock's volatility in relation to the performance of the overall stock market. The ability to correctly interpret beta can help an investor asses stock risk.
Beta is a statistical coefficient used to measure the volatility of a stock's price, or rate of return, in relation to the stock market as a whole. It can be applied to individual stocks by using statistical regression analysis and is most commonly used by financial analysts and economists. Beta is one of the primary parameters used in the capital asset pricing model (CAPM), which is used to assess an appropriate required rate of return for a stock's inherent or systemic risk.
When assessing beta, it is critical to correctly interpret beta's value, which, like other forms of statistical analysis, is centered around decimal values. If a stock is said to have a beta value between 0 and 1, that means the stock is less volatile than the overall stock market. An example of this would be utility stocks, which typically hold their value even when the overall stock market is down.
When a stock has a beta value greater that one, that means the value of the stock's price, or rate of return, is more volatile that the overall stock market. Emerging technology stocks often have beta values that are greater than one. In contrast, if a stock has a beta value equal to 0, it is said to be indirectly correlated, or the equivalent of uninvested cash when there is no inflation. Likewise, a stock with beta of 1 moves in perfect correlation with the overall stock market.
The stock market rewards those who assume the greatest risk. If an investor purchases a stock with a beta coefficient greater than 1, and the stock value increases, the investor receives a higher rate of return than someone who invested in a similarly performing stock with a beta coefficient between 0 and 1. While it is possible for a stock to have a beta below 0, it is extremely uncommon, because such a stock would have an inverse relationship with the stock market and, therefore, would have a higher return when the stock market declines.