Monday, January 14, 2013

BETA: Explained!

You may or may not recall the letter beta from your old or current college days and the infamous fraternities or sororities. It is Greek letter. Yes. but is also stands for the amount of risk a stock may have relative to the market. The market we are going to be referring to in this case is the S&P500.

What the heck is the S&P500?

Have you ever heard the saying that when you have goals they must be ‘measurable’ and you should find a way to quantify your performance in order to get a feeling of whether or not you’re in the right track or whether you should adjust your strategy? Well, the S&P 500 can be looked at as the tool most commonly used by investors to measure performance—it is commonly used as a benchmark when comparing performance of a particular stock (or other investment instruments) to the market as a whole. In a nutshell, it helps us investors figure out how our portfolio is doing in comparison to the market!

If you listen or read financial news it is likely you’ll hear about this comparison over and over again. I.e: “Stock X performed 20% better than the S&P 500 last year” or “Index Y performed 5% lower than the s&p 500”. This may also be referred to as “the market” (again, because it looks to ‘represent’ the market as a whole). As the name indicates—the S&P 500 is composed of 500 different companies from various industries and it is a weighted average: each stock’s weight is proportionate to its market value. Check out Wikipedia for a comprehensive explanation, if you wish to study this further.

We can use the performance of the S&P 500 and a company’s beta to determine the risk of a particular stock.

Keep this in mind: The ‘market’ has a fixed Beta of 1.

How do I find the Beta of a specific company?

Thanks to the wonderful world of the internet and the wealth of information that it provides; you do not have to worry about how to calculate the Beta of a stock yourself. All you simply have to do is Google it! Go to Google and type the following in the search engine:

“key statistics of  [insert your company name or its ticker symbol]

The results will look at this. Beta should be the first statistic shown:

I love yahoo finance so I would recommend you click on yahoo’s finance results and look to the right side of the ‘key statistics’ page of the company you’re looking at. There you will find the “Beta” .

So what does the S&P500 and Betas have to do with stocks? Why should I care?

Well—here is why: It all has to do with your risk tolerance. Lets say for example the stock you are looking at has a beta of 1. This means that when the S&P 500 goes up by 1% then, the stock you are looking at will also go up by 1% (from its current price). However, if the stock you are evaluating has a beta of 2; this means that the stock will go up by 2% for every 1% increase in the market. This also happens on the reverse; with a Beta of 2; if the market goes down by 1%; the stock will go down for an additional 2% below the market decrease (on average).

So, basically, with this we conclude that the higher the Beta the riskier the stock can be and the lower the beta the “safer”. When determining the kind of Beta you’d feel comfortable with is good to keep in mind the risk/return theory which says that taking big risks can result on big returns (however, remember that that opposite is also true).

A lower beta will likely give you lower and more consistent return, with a lower amount of risk--
choosing a lower beta may help you sleep better at night. However, it is all up to you and the kind of investor you consider yourself to be.

The ideal thing to do would be to figure out the “happy medium” between risk and return: a beta high enough to provide good returns yet, not so high that the stock is extremely volatile. I am pretty sure you don’t want to risk a heart attack.

For a practical view on how to apply this to the real world; lets say you are looking at two well known stocks in the same industry but one has a lower beta than the other, this can help you decide which one you’d feel more comfortable with.

So, whats your risk tolerance? do you consider yourself a cautios investor or one that likes to live on the edge?!
Note: This may seem like a lot of information to take in. However, keep in mind that I am simply explaining the meaning behind the information I am providing. When you get more comfortable with fundamental analysis, all you’ll be doing is ‘Googling” betas and figuring out whether or not they are too high or too low for your risk tolerance. I suggest you keep a notebook where you write down all the information from the research you gather while “doing homework/research” on the stock(s) you’re interested in; that way the info will be easily accessible when you need it and when is time to make your investing decisions.

So, this is the first piece of the puzzle in fundamental analysis.

Next post: Earnings. We are just getting started!

QUESTIONS? You know what to do-- email me or comment below.