Definition of Beta in Finance

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Many utilities stocks have a beta of less than 1. Conversely, most hi-tech Nasdaq-based stocks have a beta greater than 1, offering the possibility of a higher rate of return but also posing more risk.

Advantages of Beta

To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk. Indeed, if you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.
Intuitively, it makes plenty of sense. Think of an early-stage technology stock with a price that bounces up and down more than the market. It's hard not to think that stock will be riskier than, say, a safe-haven utility industry stock with a low beta.
Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. Sure, there are variations on beta depending on things such as the market index used and the time period measured, but broadly speaking, the notion of beta is fairly straightforward to understand. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.

Disadvantages of Beta

If you are investing in a stock's fundamentals, beta has plenty of shortcomings.
For starters, beta doesn't incorporate new information. Consider the electrical utility company American Electric Power (AEP). Historically, AEP has been considered a defensive stock with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP's historic beta no longer captured the substantial risks the company took on. At the same time, many technology stocks, such as Google, are so new to the market they have insufficient price history to establish a reliable beta.
Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead.
Furthermore, the beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. But for investors with long-term horizons, it's less useful.