Analyst's Toolkit: Beta and Bank of America

Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.

As we now know, banks were the incubator for the economic collapse. By looking at a measure called beta, investors could have detected increasing risk in bank stocks well before financial Armageddon.

Bank of America(BAC Quote), Citigroup(C Quote) and Wells Fargo(WFC Quote) shareholders suffered through a tumultuous year. It didn't have to be that way. Risk-averse investors could have sold off their holdings before most of the losses by paying attention to the beta value of the companies' stocks.

Beta is a measure of the systematic risk in a holding, meaning it measures the sensitivity of a stock to the market as a whole. A beta of 1 suggests that a stock and the market should move in sync. A beta of 2 means the stock will gain twice that of the market and, on the flip side, lose twice as much.

Some people confuse beta with correlation. While those measures are similar, correlation takes into account only the direction of a price change. As a result, correlation can range from plus 1 to minus 1. A correlation of 1 simply means that when the market goes up, the holding will also go up, but not necessarily by the same amount.

Beta factors in the magnitude of the change as well. Because of this added benefit, beta can be used to determine increasing or decreasing volatility vs. the market as a whole, if the observed beta is climbing. As the holding is becoming more sensitive to systematic risks, it's therefore a more risky investment.