WHAT IS BETA?

Investment analysts use the Greek letter beta ( b ) to represent the measurement of a stock's relative market risk. It measures the degree to which a stock price fluctuates in relation to the overall market -- otherwise known as the stock's volatility.

The baseline for this measurement is the overall market, which has a beta of 1. Any stock with a beta greater than 1 is more volatile than the overall market. Any stock with a beta less than 1 is less volatile than the market. Let's look at a hypothetical situation to illustrate this point.

Say a hypothetical Internet company we will call Widget.com has a beta of 2.0. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return on investment of 8 percent. We would expect Widget.com to return 16 percent. However, if the market declines and were to provide a return of -5 percent, investors in Widget.com could expect a loss of 10 percent on their investment.

Conversely, let's say that Local Telecom has a beta of 0.5. This means that it is half as volatile as the overall market. In our hypothetical market, then, Local Telecom should have a return on investment of only 4 percent when the market rises 8 percent, but should only have a negative return of 2.5 percent if the market drops by 5 percent.

Of our two companies, it is clear that Local Telecom is a much less volatile investment than Widget.com. However, Local Telecom's returns are also lower when the market has positive returns. This is the fundamental trade-off between risk and return.

Now that you have an understanding of beta and how it works, let's look at why beta is important to you.