Beta is the name given to a ratio used in investment analysis as a measure of an individual stock's volatility relative to the overall market.

To understand Beta, one first must understand systematic risk. Systematic risk is the risk inherent to the entire market or entire market segment, and is also known as un-diversifiable risk or market risk. Beta is a measurement of the risk that cannot be removed from a portfolio.

Knowledge of Beta is important to analysts, investors and management for a number of reasons:

To construct investment portfolios with the desired risk and return characteristics.

To measure the risk of a stock versus another stock or the market as a whole.

A Beta indicates to what degree a security's price is expected to move with the market, based on its past performance. A beta greater than 1 indicates that the security's price will be more volatile than the market, and a beta less than 1 means that it will be less volatile than the market.

Here is a guide to various Betas:

Beta = Zero ? this is basically cash.

Beta between 0-1 is a lower-volatility investment.

Beta of one has the same volatility as the market index, such as the S&P 500 or some other index. A person should always make note of the comparable index because the indices themselves will vary in risk.

Beta greater than one denotes anything more volatile than the broad-based index.

An example of a beta between 0-1 is Dell Computer, the stock's beta versus the S&P Index is 0.986.

This means as the market increases one percentage point Dell Computers would be expected to move up 0.986 percent, barring material news specific to the company. Imclone Systems has a high beta of 1.899 versus the S&P Index, so when the market moves up one percent it would be expected to move up 1.899 percent. If the market moves down the scenarios will be reversed.

Problems with Beta

While the beta may seem to be one good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.

Beta looks backward and history is not always an accurate predictor of the future.

Beta also doesn't account for changes that are in the works, such as new lines of business or industry shifts.

Beta suggests a stock's price volatility relative to the whole market, but that volatility can be upward as well as downward movement

Investors can find the best use of the beta ratio in short-term decision-making, where price volatility is important. If you are planning to buy and sell within a short period, beta is a good measure of risk. However, when considering long-term investment decisions, one should carefully analyse the company's fundamentals for a better picture of potential long-term risk.

Jeff Wiebe is an account manager at LOM Asset Management Limited.