Beta is a measurement of an investment’s volatility compared to similar investments, such as a market index average.
Investors and traders often talk about the “alpha” and the “beta” of a given stock. The first, the “alpha,” is the amount of return expected that is superior to the whole stock market on average.
Meanwhile, “beta” refers to how much a stock might rise or fall in a specific period of time compared to the entire stock market.
A low-beta stock is one that is expected to change in price less than the stock market. If the stock market goes up 5% in a week and down 5% the week after, a low-beta stock might move 2% higher and then 2% lower.
Beta can be applied to a single stock, a mutual fund or a specific mixture of stocks and bonds in a portfolio.
Likewise, one type of asset class, such as large-cap stocks, could be said to have low beta compared to, say, small-cap stocks or international stocks.
Everybody wants to ride the fast elevant to the top of the stock market, but what if that elevator occasionally stopped without warning and even fell 10 stories in a few seconds? Not many takers, right?
The elevator problem is exactly what happens to many non-professional investors. They happen to step on during a period eerily smooth ascent, such as the early dot-com days, then panic when stocks revert to the mean.
They want to get off, even if it means losing money permanently.
Most investors vastly prefer a smooth ascent, but they also want the fast ride. An investment with a low beta can offer something approximating a balance of the two forces — not too fast a rise, but also not as as many wild plunges along the way upward.
In the case of a portfolio, the practice of diversification is key to achieving a low beta investment experience.
Owning a percentage of bonds, for instance, can provide the ballast you need to offset the sharp declines that seem to afflict the stock market every other decade or so.
In time, those declines are erase by gains. Given more time, the stock market tends to overcome not only the downward move but adds so much more return that investors forget the previous drop and even write it off as a fluke.
Until it happens again. A low beta investment is thus a form of insurance against the risk of human nature itself, the urge to give up on stocks when times are dark and to inadvertently make paper losses permanent losses.