Using two measures of risk, namely beta

Beta is a measure of the volatility — or systematic risk — of a security or portfolio compared to the
market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the
relationship between systematic risk and the expected return for an asset (usually a stock). The CAPM is
widely used as a method for pricing risky securities and for generating an estimate of the expected
return on an asset, taking into account the risk of that asset and the cost of capital.

The beta coefficient can measure the volatility of individual stocks compared to the systematic risk of
the entire market. In statistical terms, beta represents the slope of the line through the regression of the
data points. In finance, each of these data points represents the return of an individual stock to the
market as a whole.

Beta effectively describes a security's return activity in response to swings in the market. The beta of a
security is calculated by dividing the product of the covariance of the security's return and market return
by the variance of market returns over a given period.

Beta calculations are used to help investors understand whether a stock is moving in the same direction
as other markets. It also provides insight into how volatile – or how risky – a stock is relative to other
markets. For betas to provide useful insights, the market used as a benchmark must be related to the
stock. For example, calculating the beta of an ETF bond using the S&P 500 as a benchmark will not
provide investors with much useful insight because bonds and stocks are too different.

Ultimately, an investor uses beta to try to gauge how much risk a stock adds to its portfolio. While a
stock that diverges very little from the market doesn't add much risk to the portfolio, it also doesn't
increase the potential for greater returns.

To ensure that a particular stock is compared to an appropriate benchmark, it must have a high R-
squared value in relation to the benchmark. R-squared is a statistical measure that shows the
percentage of a security's historical price movement that can be explained by the movement of the
benchmark index. When using beta to determine the level of systematic risk, a security with a high R-
squared value, in relation to its benchmark, may represent a more relevant benchmark.

Lack of Beta

While a beta can offer some useful information when evaluating a stock, it does have some limitations.
Beta is useful in determining the short-term risk of a security, and for analyzing volatility to arrive at the
cost of equity when using the CAPM. However, because beta is calculated using historical data points, it
becomes less meaningful for investors looking to predict future stock movements.
Betas are also less useful for long-term investments as stock volatility can change significantly from year
to year, depending on the company's growth stage and other factors.