What is Beta in Finance? - Definition & Formula

Instructor: Michelle Reichartz

Michelle has lead multiple training initiatives and has a master's degree in Business Administration.

In this lesson, you will learn what beta is, how it is used in finance, the formula to calculate it, and how to best utilize it for success in investing.

Knowing Your Risk

No matter what you're doing in life, you like to know the risk you're taking on. Whether it's buying a new car, finding the perfect home, deciding whether to take a new job, or tackling a new hobby, risk is a part of your everyday decisions. However, we do not blindly take on these choices, right? Anybody likes to at least have a baseline idea of how dangerous a situation can get.

However, that is a much harder challenge to take on when it comes to the financial world. When you're dipping your toes into the investment world, how can you be certain you're not taking on more risk than you're willing to take? It's an important question to ask.

One of the best ways to have a grasp of the risk you are taking is in understanding beta.

What is Beta?

Beta is the risk associated with a security or a portfolio in relation to the rest of the market. Also referred to as the beta coefficient, it is a way of determining how much a stock or security may move in comparison to the market.

The market's beta is set at 1.0. If a stock moves less than the market typically does, the stock's beta will be less than 1.0. If a stock moves more than the market typically does, the stock's beta will be more than 1.0. The basic thought is that the higher your beta is, the riskier the stock is.

To get an idea of where stocks typically land, here are a few common stocks. Utility stocks typically have a beta of less than 1. Meanwhile, high-tech stocks, such as Google and Apple, have a typical beta higher than 1. Due to the work that each company completes, the risk levels for the stock land in an area typical for their business.

Beta is commonly used in what is known as the capital-asset pricing model.

There is a downside to beta, though. Because beta depends on past performance to determine the risk level, it can be a weak way to determine future risk. Depending on the situation, the risk level in the past could be drastically different from the future. For example, a new company's beta would be very low as it has very little pricing information to determine the risk.

Capital-Asset Pricing Model

The capital-asset pricing model is a model used to calculate the expected return on an asset. This is done by using the risk associated with the asset along with the expected market returns. The capital-asset pricing model uses beta, risk-free rate, and the expected rate of return in its calculation. Capital-asset pricing model is also known as CAPM.

CAPM attempts to associate the risk with the time value of money. Beta's role in CAPM is to be the risk measure in that formula.

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