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In investing, the financial elasticity or beta risk is a ratio that depicts the price volatility of a stock or portfolio in relation to the market as a whole. A positive beta indicates that the asset fluctuates in accordance with the market, whereas a negative beta means that the asset's price moves in the opposite direction as the market. Beta ratios are indicators of the relative risk associated with investing in a given asset. Because the market, represented usually by the Standards & Poor's® Index 500 (S&P 500®), is assigned a beta value of one, any asset with a beta risk greater than one has greater price volatility and greater risk. Such assets should produce greater returns than the market yield in order to justify taking the greater risk.
For example, say Company X has a beta risk of two. This means that Company X follows the market in overall growth or decline by a factor of two. Gains of four percent in the market should coincide with gains of six percent in Company X stock. If the market, represented by the S&P 500®, is expected to return seven percent, the Company X stock should earn at least 14 percent, double the return of the market. If Company X stock does not yield a 14 percent return, then it is not a sound investment, because the higher risks should be offset by greater rewards.
Stocks with beta values of zero do not follow the trend of the market. Examples of assets with beta values of zero include United States Treasury bonds and certificates of deposit (CDs). Although these investments carry little risk of losing money, there is also an extremely low rate of return on investment. These investment options are appropriate for investors who have modest investment goals and exceptionally low comfort levels with risk.
Beta risks are calculated using complex mathematical formulas, namely, regression analysis. Investors may generate beta calculations with certain software programs using historical data for each company, or they can get the values from various online services, such as Reuters. Unfortunately, different services may report different beta ratios for the same company. Beta calculations may incorporate financial data from the past three years or five years, accounting for the differences in the values reported. Comparisons of companies using the same service, however, will provide valid comparisons of risk.
When assessing risk associated with certain investments, beta risk calculations have several drawbacks. They are dependent on both the direction and the magnitude of changes in prices. A rapidly rising stock price in a slowly rising market will have a high beta, but as the stock price increase slows, then the beta will approach that of the market. Beta risks are based on historical data that may have no bearing on future risks. Also, major changes in an industry can introduce elements of risk that may not be reflected accurately in the beta risk calculations. For these reasons, most investors use betas for short-term investment decisions, but long-term strategies are best determined through study of other financial data.
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