Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. Beta is a relative measure of an individual stock’s risk relative to all stocks’ market portfolios.
It is important to note that beta measures a security’s volatility, or fluctuations in price, relative to a benchmark, the market portfolio of all stocks, such as the SENSEX or NIFTY.
Beta helps compare the relative systematic risk of different stocks and, in practice, is used by investors to judge a stock’s riskiness. Stocks can be ranked by their betas. Because the market variance is a constant across all securities for a particular period, ranking stocks by Beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities.
Understand What Beta value Indicates
Beta > 1
A beta greater than 1.0 means that the individual security has historically been more volatile than the market. For example, if the security’s return has increased 20% when the market return increased by 8%, the security has a beta of 2.5. This means that on average, when the market rises by 1%, this stock’s price should increase by 2.5%. Thus, the increase in the individual stock’s return will be 250% of the rise in the return of the market.
Beta < 1
A beta of less than 1.0 but greater than zero means that the individual security has historically been less volatile than the market. For example, if the market return has increased by 12% and the security’s return has increased by only 4%, the security has a beta of 0.33. This means that the increase in the return of the stock is 33% of the market’s return.
Beta = 1
A beta of exactly 1.0 means that the individual security has historically moved in tandem with the market. A stock whose returns are perfectly correlated to the returns of the market (meaning that the return of the security has historically been the same as the return to the market) has a beta of 1.0. This stock has the same systematic risk as the market (or as the benchmark index). The market has a beta of precisely 1.0.
Beta = 0
Risk-free security has a beta of zero. However, just because security has a zero beta does not mean it is risk-free. It means only that there is no correlation between that security’s return and the return of the market.
Negative Beta Coefficient
A negative beta (less than zero) means the security has historically moved counter to the market. The security’s price decreases when the demand increases, and vice versa. Some precious metals and precious metal stocks have negative betas because when the market goes down, their market price goes up, and when the market goes up, their market price goes down.
Examples of Beta Calculation
Example: Consider a high-tech stock with a Beta of 2. This means the stock is twice as volatile as the market. Therefore:
- If the market return is 10%, Individual stock return would be 20% (10% x 2 = 20%)
- If the market return is -8%, then the individual stock return would be -16% (-8%*2)
Advantages of Beta
The calculation of Beta is based on finance theory. For example, suppose you’re thinking about investing in a company’s stock. In that case, the Beta allows you to understand if the price of that security has been more or less volatile than the market itself, and that’s undoubtedly a good thing to know about a stock you’re planning to add to your portfolio.
If we understand the theory behind Beta, it’s easy to understand how emerging tech stocks typically have beta values greater than 1. In contrast, years-old utility stocks typically have beta values of less than 1.
Disadvantages of Beta
If you’re calculating stock beta values using price movements over the past three or five years, you need to remember that past performance is no guarantee of future returns. This rule applies to Beta also.
Beta is calculated based on historical price movements, which may have little to do with how a company’s stock is poised to move in the future. And because the measure relies on historical prices, it may not be easy to accurately calculate the Beta of newly issued stocks.
So, while Beta can tell us something about the past risk of a security, it tells us very little about the attractiveness or the value of the investment today.
Bottomline: Investment Strategies using Beta
In financial markets, beta factors can have a significant influence on the investment strategies of investors. If the analysis is to be believed, in times of a bull market, i.e., rising markets, investors that held stocks with a high positive beta factor since should outperform the market. During the bull phase market moves up and may reach its peak, and those investors who held high positive beta factors made excess returns and did far better than the relative index performances.
However, in bear markets, i.e., falling markets, investors should target low beta stocks since they should outperform the market.