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Beta Defined – Guest Post

Site Administrator | February 1, 2012

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Special thanks to our friends at Benzinga for the following guest post by Jayson Derrick:

Investors can be intimidated by the plethora of information involved in selecting a stock that is suitable for their investment objectives. One of the pieces of information is a variable known as ‘beta', a Greek letter β. The purpose of this article is to explain what beta is, how it can be calculated using basic excel knowledge and its importance in picking a stock that fits in with investment objectives.

Beta defined

Beta is a historical measure of the volatility or systematic risk of a stock and how it relates to the market as a whole. In simpler terms, beta provides a guideline of how a stock should typically “move” with the market based on the data collected and analyzed. Usually the performance of the S&P 500 (NYSE: SPY [FREE Stock Trend Analysis]) is used to represent the market as a whole Click here for more information on ETFs. A beta of 1 means the stock is less volatile than the market while a beta of greater than 1 indicates that the stock will be more volatile than the market. If a stock has a beta of 1.5 this means that if the market were to rise 10%, the stock would rise 15% based on the historical information. If the market were to drop 2%, the stock would lose 3% based on the historical information. It is important to understand that beta is a historical measure and may have periods of volatility that are higher or lower than expected.

Advantages and disadvantages involved?

Both low and high beta stocks have advantages and disadvantages. A low beta stock is considered to be more stable and will experience gains when the market is appreciating, however these gains will be less than the market as a whole so an investor is missing out on a return he would have gotten had the invested in the S&P 500 ETF (NYSE: SPY). When the market is dropping, a stock with a low beta will experience less of a drop and the investor is in a better position now with the stock as opposed to investing directly in to the S&P 500 ETF (NYSE: SPY)

On the flip side, a stock with a high beta will rise more rapidly and outperform the market and an investor is better off having invested in this stock as opposed to the S&P 500 ETF (NYSE: SPY.) However, with the prospect of a larger return comes the possibility of larger losses. A stock with a high beta will lose more value than the market as a whole and investor is now in a position where his losses would have been less had he invested in the S&P 500 ETF.

The next step is for you to think carefully of your investment objectives and your tolerance for risk. Low betastocks are less risky but offer less reward. High beta stocks are more risky and offer higher rewards. Here is a list of sectors to consider:

Low beta:

  • Electric utility
  • Retail/wholesale food
  • Educational services
  • Tobacco/beverage

High beta:

  • Semiconductor equipment
  • Hotel/hospitality/gaming
  • Metal fabricating
  • Private equity/financial services

Calculating beta using excel

Let's assume you want to calculate the beta of excel using daily closing figures of NYSE:MGM for 1 year. This is done in several easy steps:

Step 1:

Gather historical closing prices for BOTH MGM and S&P500 for 1 year. These can be downloaded from any popular financial website such as finance.yahoo.com. It is vital to use the “Adjusted Close” which takes in to account any dividends or stock splits.

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Step 2: Calculate daily returns for both MGM and S&P500

The easiest way to do this is to make use of the formula function on excel. Keep in mind the daily return = price on closing day divided price on previous closing day minus 1.

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Step 3: Calculate daily return for every day.

This is accomplished by dragging your mouse to the bottom corner of cell D2 and just dragging the bar all the way down so every closing price has a corresponding daily return.

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Step 4: Use the slope function

Using the slope function is an easy way to calculate the beta of MGM. The slope function is in indication of how MGM is related to S&P500. We are interested to know what happens to MGM when we have multiple readings of S&P500. MGM is the dependent value (the one that gets changed) Take note of the formula on top. Excel will prompt you for 2 variables: x and y. The y variable is the daily return of MGM, while the x variable are the daily returns for the S&P500. The corresponding value is our beta.

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From this exercise we have calculated the beta of MGM to be 1.71 which is quite large.

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As we can see from the chart above MGM (in blue) experiences significantly higher drops in share price when the S&P500 (in red) is falling. MGM also experiences significantly higher gains in share price when the S&P 500 appreciates in value.

Conclusion

To conclude fully understanding the beta of a stock allows an investor to match up a stock selection to his risk profile and tolerance for less. Suppose an investor wants to minimize losses as much as possible, he would select a stock that has a low beta so that during times of a declining market the investor should lose the least possible. An investor that has a high risk tolerance might find stocks with a high beta suitable in hoping that a rising market will multiply returns in a stock.

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Risk Disclaimer: Past performance is not indicative of future results. Futures trading involves substantial financial risk. Views of guest commentators do not represent those of TradingPub.com.  Article intended for educational purposes only and not meant in anyway as a solicitation to buy or sell certain securities.  Please consult your personal financial adviser before using this information for your own trading purposes.