Breaking down Beta

The financial landscape in Jamaica today is experiencing record low interest rates, record low inflation and record low unemployment. These among other signals tell us that Jamaica’s economy is in a strong position and it has influenced more persons to invest in the Jamaica Stock Exchange to achieve their investment objectives. Stocks can provide higher returns for investors but with higher returns, come increased risk. One way to assess risk is to consider what is called ‘beta’.

What is Beta?

‘Beta’ is a measure of how much a stock moves in relation to the overall stock market. If Nike stock had a beta of 1, that means it moves in sync with the stock market. This means when the stock market goes up, the price of Nike stock goes up and if the stock market goes down, Nike’s stock price falls.

If Nike stock had a beta above 1, say 1.3, it means that when the market moves, Nike’s price will overreact by 30%, because it is seen as 30% more volatile. If Nike stock had a beta of 0.7, that means the price underreacts by 30% in comparison to the market, as it is seen as less volatile relative to the market. If Nike had a negative beta, say -1.3, it means that when the market goes up, Nike’s price would go in the opposite direction.

Summary

Beta shows the relationship between a stock’s movement and the market’s movement.  Therefore, stocks with a higher beta are more volatile, while stocks with lower betas are less volatile.  As volatility is a measure of risk, investors with a higher risk tolerance may select stocks with higher betas while clients with a lower risk tolerance may select stocks with lower betas.

Another way to achieve lower volatility as an investor is to diversify stocks by combining stocks in a portfolio with high, low and negative betas or by investing in a mutual fund which holds a diversified equity portfolio. In a diversified equity mutual fund, the portfolio may be comprised of stocks with betas ranging from positive to negative and likely resulting in lower risk and a higher return in the long run.