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Wednesday, October 6, 2010

Stocks and the Beta Coefficient

The Beta Coefficient is a means of measuring the volatility of a security or of an investing portfolio of securities in comparison with the market as a whole.

In other words, Beta is the sensitivity of a stock's returns to the returns on some market index.

Beta is calculated using regression analysis. A Beta of 1 indicates that the security's price will move with the market. A Beta greater than 1 indicates that the security's price will be more volatile than the market and finally, a Beta less than 1 means that it will be less volatile than the market.

Beta values can be roughly characterized as follows:

* Beta Equal to 0: Cash under your mattress, assuming no inflation.

* Beta Between 0 and 1: Low-volatility investments (e.g., utility stocks).

* Beta Equal to 1: Matching the index.

* Beta Greater than 1: Anything more volatile than the index.

Most new high-tech stocks have a Beta greater than one, they offer a higher rate of return but they are also very risky. The Beta is a good indicator of how risky a stock is.

The more risky a stock is, the more its Beta moves upward. A low-Beta stock will protect you in a general downturn.

That's how it is supposed to work, anyway. Unfortunately, past behavior offers no guarantees about the future. Therefore, if a company's prospects change for better or worse, then its Beta is likely to change, too.

So, be extremely cautious and use the Beta Coefficient only as a guide to a stock's tendencies.