What is BETA in Stocks?
The beta value of stocks is derived using a quantitative approach and indicates the volatility of a stock’s price to changes in the overall stock market. Stock beta is represented numerically and calculated by comparing the asset’s historical performance with its benchmark’s past performance. It is often used as a critical metric to determine the associated risks with an investment.
What is Beta in Stocks?
It is a well-known fact that stock market investments can generate higher returns than some traditional investments; however, higher returns come with higher risks. The risks and returns are directly proportional, i.e. risky investment leads to higher returns, and assets with lower risk may yield lower returns. While this theory holds true in the stock market, investors should exercise caution and research before investing in risky investments. Investors need to assess their risk appetite and invest in stocks that limit risk exposure. Not all risky investments may generate high returns – some investments are risky and headed to doom. One way to gauge the risks associated with any investment is through its Beta value. Stock beta determines how volatile the stock is when compared to the benchmark. This article elaborates on what is beta and beta value of stocks.
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How does Beta work?
In simple words, the beta value of stocks represents a stock’s responsiveness to the volatility experienced by the stock market. The stock markets are highly volatile and impacted by various factors. While investors can predict some of these factors or events, certain events are unforeseen and can affect the stock markets. Thus, it becomes essential for investors to understand how the stocks perform during such uncertain events. These events are also known as systematic risks i.e. the risks which are not restricted to a particular investment but applicable to the market as a whole. Beta values analyze the stocks through the lens of systematic risks and interpret their performance.
How to use beta to evaluate a stock’s risk?
Beta in the stock market helps investors understand the risk related to a particular security before investing. Let us look at the different types of beta values and their interpretation.
- β > 1: Stocks with beta values greater than one are commonly high-risk and potentially high-reward securities. Such stocks may have a high degree of responsiveness compared to the markets and may generate substantial investment returns. Many small and mid-cap companies have a beta value of more than one.
- β < 1: Stocks exhibiting a beta value of less than one indicates better stability. During bearish times, these stocks fall less than the index. Investments made in such stocks remain relatively stable.
- β = 1: The Beta value of one implies that the stock’s volatility is the same as that of the broader market. Many large-cap companies have a beta value of one.
- β = 0: Securities such as fixed deposits and government bonds may have a beta value of zero. Such investments are ideal for capital preservation as they carry relatively negligible market associated risks.
- β < 0: Securities exhibiting an inverse relation with the stock markets carry a negative beta. An example of a negative beta is gold and signifies that its value may rise over time irrespective of the performance of the stock market indices It acts as a hedge against inflation and is a preferred choice for investors to hedge their investments.
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Pros and cons of using beta
Beta in the share market is often used as one of the essential metrics to analyze the investment. It helps the investors identify an asset that aligns with their risk appetite. Let us understand some of the key advantages and disadvantages of beta.
Advantages:
- Beta values measure the systematic risks associated with the stocks. Systematic risks apply to the market as a whole, and the beta value is an indication of how volatile the stock is when such risks impact the market – for example, economic reforms announced by the government, financial budget etc.
- Beta value is determined by using a quantitative approach that analyses the stock’s past performance and the benchmark. Investors can rely on the beta values since they are derived quantitatively and not through any estimates or forecasts. It is reflective of the past performance.
Disadvantages:
- While the beta value of a stock considers the systematic risks, it does not indicate the unsystematic risks associated with the asset. Unsystematic risks are internal to the organization and applicable to their shares. For example, stocks with a beta value of less than one or stable stocks may develop unsystematic risks that can cause their price to plummet. Hence, while beta is a strong indicator of risk, it cannot be the only basis for making an investment decision.
- Beta value is derived by analyzing the past performance or returns yielded by the stock. However, it gets tricky when there is no past data available for an asset or if the stock is new to the market. In such a case, a proxy dataset of returns generated by a similar company is considered. It may not be a true representation of the stock.
How to calculate Beta?
Investors can source the beta value through various online platforms. Alternatively, investors can also calculate the beta value by using the following methodology.
Step 1: Download historicals – The primary requirement to calculate a beta value is the availability of historical stock prices and index prices for the specific timeframe. Investors can download this from their preferred source.
Step 2: Calculate the percentage change in prices – Compute the percentage change in prices for stock and the index.
Step 3: Calculate Beta
The formula for calculating beta is
𝛃 coefficient = Covariance (Re, Rm) / Variance (Rm)
Re = The return on an individual stock
Rm = The return on the overall market
Covariance = How changes in a stock’s returns are connected to the changes in the market’s returns
Variance = How far the market’s data points spread out from their average value
Covariance is derived using the statistical regression tool to measure the relationship between two variables. Covariance denotes the relation between the stock returns and market returns by studying the changes in their respective prices over a specific period. A positive covariance indicates the stock and market returns are moving in the same direction. In contrast, a negative covariance value suggests that the stock returns and market returns move in different directions.
On the other hand, Variance is calculated by squaring the standard deviation value of market returns.
What is the beta value of stocks?
The beta value of stocks is represented numerically and can be used to gauge how the stock responds to market volatility. The stock market has various participants with different financial objectives, and the investors follow different strategies to achieve their goals. One crucial factor that helps investors choose an appropriate investment strategy is their risk appetite. While some investors are risk-takers, some are risk-averse, and some are in-between or moderate risk-takers. Since stock beta is a measure of the stock’s responsiveness to market risks, it becomes one of the crucial metrics for investors at the time of making investment decisions. It helps them align their investments with their respective risk appetite. Beta values can also help the investors balance their portfolio from a risk perspective, i.e., have a portfolio that comprises stocks with high, low, and medium beta values.
Summing up
Investors seeking a simple answer to what is beta in the share market can refer to the following key takeaway. Beta represents the stock’s performance compared to the benchmark by evaluating its past returns. Ideally, beta calculations consider the past performance of 2-3 years to derive a logical conclusion. The investors analyse beta values to align their investments with their risk appetite. Investors must also understand that beta value cannot be the only factor in building an investment portfolio. Stock market investments require a thorough analysis of multiple metrics and fundamentals.