The world of investing and portfolio management seems to have a language all its own. It’s full of unique financial jargon and terms. And while terms like “dividend”, “price-earnings ratio”, or “junk bonds” are pretty commonplace and are well known by most investors, there is plenty of jargon that’s ignored by the average investor. But some of these odd-ball terms might actually do your portfolio some good.
Case in Point: Beta
The statistical measure of a stock or security is a critical component to crafting a well-diversified portfolio, and yet most investors don’t give it a passing glance, which is a shame. A quick lesson on beta and how investors can use it can make all the difference in crafting a winning ETF portfolio.
Beta: Defining Sensitivity
Most investors should be familiar with the concept of volatility, especially after the last few years of returns. At its core, beta hopes to quantify the concept of a stock’s or other asset’s “jumpiness” into a neat easy-to-digest package. By using regression analysis, analysts hope to measure the volatility of a security or a portfolio of securities versus the broader market as a whole.
Basically, it’s how much a stock will jump relative to all stocks. Typically, all stocks refers to a broad market measure like the S&P 500, however, you really can use any index measure, even bonds or commodities.
When calculating the beta coefficient of a particular security, a reading of 1 means that the security’s price jumps will move roughly with the market. So when looking at the S&P 500, an index fund designed to track it, like the SPDR S&P 500 ETF (SPY ), will have a beta of 1 since it’s designed to track the S&P 500 exactly.
A beta of less than 1 means that the security will be less volatile than the overall market. A prime example of that would be megacap stocks. Their much larger size and stature makes them a safer bet than smaller stocks. A look at the SPDR Dow Jones Industrial Average ETF (DIA ) confirms this. The Diamonds have a five-year beta of 0.94. The Dow Jones tracks some of the largest stocks in the United States.
A beta of less than 1 can also mean that a security is actually indeed a volatile investment but its price movements are not highly sensitive to the market. Gold and the SPDR Gold Shares (GLD ) are prime examples of this. Gold tends to have large daily price swings, but not in the same direction as the overall market. When the market is going down, people rush to safe havens like gold. As a result, GLD has a five-year beta of 0.12.
A beta of greater than 1 indicates that the security’s price will be more jumpy than the broader market. We all know that small-caps are more volatile than large-caps, and the beta coefficient confirms the bias. The uberpopular and $25 billion iShares Russell 2000 Index ETF (IWM ) has a five-year beta of 1.21. That means IWM will bounce around a lot more, 20% more, in fact, than the broader S&P 500.
Sometimes, the beta measurement can actually be negative. This simply means that an investment will do the opposite of the broader market. For example, bonds typically drop in price when the stock market rises and vice versa. The broad investment-grade bond benchmark ETF, the Vanguard Total Bond Market ETF (BND ), has a five-year beta reading of -0.04. And it’s not just bonds, some investments like derivatives and put options tend to have consistent, negative beta readings.
Putting It All Together
So now that we know what beta is and what it means, the real question is how you can use it.
The biggest advantage of this measure comes down to diversification. Most investors think they are diversified, but in reality they are not. By looking at the various betas of their underlying holdings, investors can attempt to find asset classes that move in different ways and magnitudes in regards to each other. You can actually create a much more balanced portfolio this way. Beta is slightly different than correlation, but it can function in a similar fashion.
Second, investors can use it to address their risk tolerance. Getting a little seasick looking at how much your portfolio of stocks moves around? Check its beta. Odds are it has a reading of above 1. You can use the measurement to either sell high-beta holdings or buy those asset classes that have less than 1 or negative betas.
Finally, for short-term investors, beta can be used to gauge returns. Assets with a beta of 1 should match the market’s underlying return on a given day. If the market surges by 5%, then the price of a matching beta stock should also climb by roughly 5%. For traders, beta can be used to find stocks or ETFs that should do better than the broader market for that single day.
The Bottom Line
Beta is one of the most misunderstood and ignored financial metrics and terms out there. However, its basic principles are actually easy to use and understand. Investors can use the concept to their advantage when constructing their portfolios using ETFs, stocks, bonds or other assets.