how investors use beta
an investor uses beta to gauge how much risk a stock adds to a portfolio while a stock that deviates very little from the market doesn t add a lot of risk to a portfolio it also doesn t increase the potential for greater returns investors must ensure a specific stock is compared to the right benchmark and review the r squared value to the benchmark r squared is a statistical measure that compares the security s historical price movements to the benchmark index a security with a high r squared value indicates a relevant benchmark a gold exchange traded fund etf such as the spdr gold shares gld is tied to the performance of gold bullion 1 consequently a gold etf would have a low beta and r squared relationship with the s p 500 investors commonly evaluate two categories of risk systematic risk is the risk of the entire market declining called un diversifiable unsystematic or diversifiable risk is the uncertainty associated with an individual stock or industry it is risk related to a company or sector and can be mitigated through diversification a stock s beta will change over time as it relates a stock s performance to the returns of the overall market theory vs practicethe beta coefficient theory assumes that stock returns are normally distributed from a statistical perspective in reality returns aren t always normally distributed therefore what a stock s beta might predict about a stock s future movement may prove untrue a stock with a very low beta could have smaller price swings yet still be in a long term downtrend so adding a down trending stock with a low beta decreases the risk in a portfolio only if the investor defines risk strictly in terms of volatility and not potential losses similarly a high beta stock that is volatile in a mostly upward direction will increase the risk of a portfolio but it may increase gains investors who beta to evaluate a stock also evaluate it from other perspectives such as fundamental or technical factors before assuming it will add or remove risk from a portfolio 