Statistically Beta shows the sensitivity of a security. The Beta is a measure of the systematic risk of a security. Systematic risk refers to the risk that cannot be avoided through diversification. Hence, Beta measures non-diversifiable risk. It is a relative measure of risk. Beta is a statistical measurement indicating the volatility of a stock’s price relative to the price movement of the overall market. Beta is an extremely useful tool to consider when building a portfolio.
Higher-beta stocks are more volatile and are therefore considered to be riskier but are in turn supposed to provide a potential for higher returns.
Low-beta stocks are less riskier but also they are expected to give lower returns.
The market itself has a beta value of 1; in other words, its movement is exactly equal to itself (a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. An asset with a beta of 0 means that its price is not at all correlated with the market; that asset is independent.
A positive beta means that the asset generally tracks the market.
A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up.
Formula to measure Beta
= Beta of the security with market
= Covariance between security and market
= Variance of market returns
= Coefficient of Correlation between security and market returns
Consider the stock of XYZ Ltd has a beta of 0.75. This points to the fact that based on past trading data, XYZ Ltd as a whole has been relatively less volatile as compared to the market as a whole. Its price moves less than the market movement. Suppose Sensex index moves by 1% (up or down), XYZ Ltd’s price would move 0.75% (up or down respectively). If XYZ Ltd has a Beta of 1.3, it is theoretically 30% more volatile than the market. Beta can also considered to be an indicator of expected return on investment. Given a risk-free rate of 4%, for example, if the market (with a beta of 1) has an expected return of 8%, a stock with a beta of 1.4 should return 9.6% (= 4% + 1.4(8% - 4%)).
Downside of Beta
The Beta is just a tool and as is the case with any tool, is not infallible. While it may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.
•Beta is not a sure thing. For example, the view that a stock with a beta of less than 1 will do better than the market during down periods may not always be true in reality. Beta scores merely suggest how a stock, based on its historical price movements will behave relative to the market. 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. Indeed, a stock’s beta may change over time though usually this happens gradually.
As a fundamental analyst, you should never rely exclusively on beta when picking stocks. Rather, beta is best used in conjunction with other stock-picking tools.
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