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What is beta and how can understanding it help you invest smarter?

As you build up your investing knowledge and experience you’ll start to come across a virtual smorgasbord of different metrics and fundamental ratios that analysts use to compare stocks. Most of the more common ratios, like a stock’s P/E, are pretty intuitive and easy to understand – and you might even find yourself employing some of these tools when conducting your own investment research.

One metric a lot of people overlook when making their investment decisions is beta. And I can understand why. For most people, anything named after a letter of the Greek alphabet triggers flashbacks to horrible high school math classes. It just instinctively feels too complex and esoteric. But beta is actually surprisingly easy to understand. And once you grasp what it is telling you about a stock, it can be a useful addition to your investing toolkit.

So what is beta?

Put simply, beta is a measure of risk. We don’t have to go into exactly how it is calculated, but essentially it tells you how volatile a stock is relative to the market as whole. The market itself will always have a beta of exactly one. So if a stock’s beta is less than one it indicates that historically, on average, it has exhibited less volatility than the market. If a stock’s beta is greater than one, it has exhibited more volatility.

An example might help to explain the concept. According to Yahoo Finance, Telstra Corporation Ltd (ASX:TLS) has a beta of 0.57. This tells us that, historically and on average, whenever the market has risen or fallen by, say, 10%, shares in Telstra have only risen or fallen by 5.7%. This shows you why Telstra has for so long been the darling of any income investor’s portfolio. Its shares have exhibited lower volatility than the overall market and continued to pay out hefty dividends.

Compare this with another big blue chip, BHP Billiton Limited (ASX:BHP). Yahoo Finance calculates its beta as 1.26. This means that, on average, shares in BHP have exhibited 26% more volatility than the market. So historically, when the economy is going well and the ASX is reaching new highs, BHP shareholders have seen the value of their investments grow impressively.

However, when the market has crashed, BHP’s shares have been punished more than most.

This is why I said beta is a measure of risk. Sure, a high beta stock might be great to hold when the economy is booming, but during a slump they can put massive downward pressure on your portfolio.

How can you use beta for stock selection?

Beta can be a useful tool when you’re trying to diversify, as it will help you find stocks that reduce the overall market risk exposure of your portfolio.

Continuing the example of BHP and Telstra, if you owned both these stocks instead of just one, the overall beta for your portfolio would be somewhere in between that of BHP and Telstra. So if you’re a BHP shareholder and you add more defensive stocks like Telstra to your portfolio, you will effectively reduce the overall volatility of your returns.

You can even invest in ETFs like the BetaShares Australian Equities Bear Hedge Fund (Shown in Google Finance as BETA BEAR/ETF (ASX:BEAR)), which aims to move inversely with the overall market, meaning it would actually have a negative beta. Adding investments like this to your portfolio can help to smooth your returns and make you less exposed to wild swings in the market.

Foolish takeaway:

Building a stock portfolio based on beta alone probably isn’t going to deliver you particularly outstanding results.

For one thing, betas can change over time. Plus, they can be calculated in many different ways. For example, some analysts might calculate beta using returns for the whole market, or just a portion of it, like the ASX200. Analysts might use monthly returns over a five year period, or weekly returns over a 3 year period, or anything in between.

But nevertheless, a stock’s beta does tell you something about the nature of an investment. It gives you an indication of how risky it is, and whether it will provide diversification benefits to your portfolio. Used in combination with other financial metrics, ratios, and company research, beta can be another helpful tool for smarter stock selection.

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Motley Fool contributor Rhys Brock has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Telstra Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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