The beta coefficient is a form of measurement for volatile movement in an individual stock, as well as systematic risk in comparison to comparable stocks or the wider market. Beta is a representation of the trajectory output of the slop calculated through regression analysis of a particular stock vs sector vs wider market.
Re = Return on individual stock
Rm = Return on the 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.
When a security experiences price movement ‘rubber banding’ or ‘swings’, beta justifies this activity.
You can measure Beta in three steps:
- Identify the target of the covariance;
- Divide the covariance against the variance of the market;
- Over defined period;
This calculation is used to measure if there was any movement of the stock against the wider market, including the volatility-risk in comparison to its sector or wider market.
The target return used in the beta calculation must be related to the particular stock, as an investor you would be trying to ascertain the risk of that particular stock and the effect of that risk to your wider portfolio. If the stock has a strong deviation from the market, then it would add a lot of risk to your portfolio but could also provide greater return potential in comparison to lesser risk investments.