Beta, meanwhile, is a relative risk measurement, because it depicts a fund's volatility against a benchmark. Morningstar calculates betas for stock funds using the S&P 500 Index as the benchmark. We also calculate betas using what we call a fund's best-fit index, which is the benchmark whose performance most resembles that of the fund. For bond funds, for example, we use the Barclays Capital Aggregate Bond Index and best-fit indexes.
Beta is fairly easy to interpret. The higher a fund's beta, the more volatile it has been relative to its benchmark. A beta that is greater than 1.0 means that the fund is more volatile than the benchmark index. A beta of less than 1.0 means that the fund is less volatile than the index.
In theory, if the market goes up 10%, a fund with a beta of 1.0 should go up 10%; if the market drops 10%, the fund should drop by an equal amount. A fund with a beta of 1.1 would be expected to gain 11% if the market rises by 10%, while a 10% drop in the market should result in an 11% drop by the fund. Conversely, a fund with a beta of 0.9 should return 9% when the market goes up 10%, but it should lose only 9% when the market drops 10%. The biggest drawback of beta is that it's really only useful when calculated against a relevant benchmark. If a fund is being compared with an inappropriate benchmark, its beta is meaningless.
There's another statistic that is often overlooked in this discussion of volatility: R-squared, which you can find under the Ratings & Risk tab of a fund's report on Morningstar.com. The lower the R-squared, the less reliable beta is as a measure of the fund's volatility. The closer to 100 the R-squared is, the more meaningful the beta is. Gold funds, for example, have an average R-squared of just 0.26 with the S&P 500, indicating that their betas relative to the S&P 500 are pretty useless as risk measures. Unless a fund's R-squared against the index is 75 or higher, disregard the beta.