What is beta?

Buying stocks has risks associated with it. As investors, how do we tell what's the risk in buying a particular stock? Beta is a popular indicator of risk as a statistical measure. Analysts use this measure often when they need to determine a stock's risk profile.

Beta is a measure of a stock's volatility in relation to the market. By default, the market has a beta value of 1. Stocks are then ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta value of more than 1. On the contrary, the stock's beta value is less than 1.0. The higher the beta-value of the stock, the riskier the stock but also a higher potential for higher returns; low-beta stocks pose less risk but also lower returns.

Theoretically, beta measures more of undiversified compared to diversified risk. In finance theory, you are awarded more for holding undiversified risk rather than risk that can in theory be diversified away by obtaining a more balanced portfolio. By diversifying this form of risk, you can theoretically reduce risk but not sacrifice returns.

Beta is actually used in the very famous Capital Asset Pricing Model (CAPM) to find out the required rate of return used in many financial models.

The problem with beta is that it measures historical volatility and not prospective volatility, so new information regarding particular stocks may not be factored into Beta calculation