how beta works
a beta coefficient shows the volatility of an individual stock compared to the systematic risk of the entire market beta represents the slope of the line through a regression of data points in finance each point represents an individual stock s returns against the market beta effectively describes the activity of a security s returns as it responds to swings in the market it is used in the capital asset pricing model capm which describes the relationship between systematic risk and expected return for assets capm is used to price risky securities and to estimate the expected returns of assets considering the risk of those assets and the cost of capital calculating betaa security s beta is calculated by dividing the product of the covariance of the security s returns and the market s returns by the variance of the market s returns over a specified period the calculation helps investors understand whether a stock moves in the same direction as the rest of the market it also provides insights into how volatile or how risky a stock is relative to the rest of the market for beta to provide useful insight the market used as a benchmark should be related to the stock for example a bond etf s beta with the s p 500 as the benchmark would not be helpful to an investor because bonds and stocks are too dissimilar beta coefficient covariance r e r m variance r m where r e the return on an individual stock r m the return on the overall market covariance how changes in a stock s returns are related to changes in the market s returns variance how far the market s data points spread out from their average value begin aligned text beta coefficient beta frac text covariance r e r m text variance r m textbf where r e text the return on an individual stock r m text the return on the overall market text covariance text how changes in a stock s returns are text related to changes in the market s returns text variance text how far the market s data points spread text out from their average value end aligned beta coefficient variance rm covariance re rm where re the return on an individual stockrm the return on the overall marketcovariance how changes in a stock s returns arerelated to changes in the market s returnsvariance how far the market s data points spreadout from their average value beta values