Candlestick Trading Blog

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Understanding a Stock’s Beta
It actually sounds a little strange, doesn’t it? If you don’t understand a stock’s beta you are not alone. While it is overused by some people, this is actually another good ratio to have available for fundamental analysis of a particular stock. But so we don’t get too far ahead of ourselves, let’s discuss a stock’s beta.

What is a stock beta?
A stock beta is ratio that can be used to suggest stock volatility. By understanding volatility an investor can better understand the investment risk of a stock. Once risk is identified the risk premium can be calculated and an investor will have a better awareness of whether the stock’s return can justify the risk.

Now for the formula. Take the S&P 500, it is the most common index for this function and probably the most reflective of the entire market, and designate it as your baseline with a ratio of 1.

Let’s look at a couple of examples. MEW Industries has been a very stable company; you check the stock market on the Internet and its beta is 1. Since the market has an expected return of 8% and a beta of 1, your beta is 1 as well. This quick evaluation suggests that MEW Industries should bring 8%. In our second example, ABC Corp. is a young technology company with a lot of potential. The stock beta for ABC Corp is 3; since the market beta is 8%, the stock beta for ABC Corp is 24%. This sounds like a great investment, but since this is only one test, further analysis is needed.

What does stock beta tell you?
Stock beta gives you an idea about how volatile a particular stock is. After you know that, applying your fundamental and technical analysis can help you draw a conclusion about the risk premium of a stock. Stock betas over 1 indicate increased volatility and those below 1 are considered to be less volatile.

Does stock beta have any flaws?
First lesson when investing in the stock market; every ratio has its limitations. This is the reason that performing stock technical analysis requires more than one ratio. Some of the limitations of stock beta are:

• Beta looks backward and history is not always an accurate predictor of the future.



• Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts.



• Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.