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Beta is very important when analyzing stocks. It gives you a gauge of how volatile the stock can be without you adding subjective judgment. Great explanation!
Beta is the expected relationship between an individual stock’s return and the market return. I.e. it is the coefficient in the simple regression of stock return on market return. As you say, a stock with beta of 2 can be expected to return twice the market return, so if the market is up 10% you would expect the stock to be up 20%. However, stocks with betas less than one but larger than zero are not negatively correlated to the market as you have stated. A stock with a beta of 0.5 would be expected to return half the market return, so if the market is up 10% you would expect the stock to gain 5%.
Stocks with negative beta are inversely related to the market, so a stock with a beta of -1.0 would be expected to go in the opposite direction of the market but in the same magnitude. E.g. if the market is up 10% you would expect that stock to be down 10%. It is not clear that stocks with negative betas exist in the real world, other than such things as short funds.
Beta is indeed, as you say, a measure of risk. However, it is not a complete measure of risk, only a measure of one aspect of it. Stocks with high betas are by definition relatively volatile, because the market is volatile, but stocks with low betas are not, as you state, necessarily low risk. The classic example is a small biotech which could be very volatile but have a beta of zero, as it will go up or down based on the results of drug trials, etc.
Generally, the term alpha is used to refer to a manager’s stock picking value added, and is not used to describe a particular stock. Strictly speaking, it is the intercept of the regression mentioned above, not the error term, so even if applied to a single stock would not, as you say, represent everything that affects a stock returns other than beta.
“When you see beta less than 1, it means that the stock goes down every time the market goes up. ”
Can I point out that this is just plain wrong? A beta of less than 1.0 does not mean an asset has a negatively correlation with the market. If an asset has a beta of less than 1.0 but greater than 0.0, it means the asset goes up when the market goes up but not as much as the market. It also means that the asset does not fall as much when the market declines.
The following statement is wrong:
“If the stock moves exactly as the market does, the beta of it will be 0.”
Corrected, the statement should be:
“If the stock moves exactly as the market does, the beta of it will be 1”
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