Beta is an important term related to investment and finance. The Beta of an investment is a number that describes the correlates the volatility of an asset with the volatility of a benchmark of the particular asset. The ideal benchmark has a beta of 1.0. Investments are compared to the benchmark as per the level of movement deviation from benchmark.
Generally, the NIFTY50 or Sensex stock indices are used as the “benchmark” for measuring the risk of other investments in order to understand the volatility of the stock.
Definition of Beta (β)
Beta (β) of the stock measures the volatility of returns related to the entire market. Beta is used as an indicator to measure the risk and is an important part of the CAPM (Capital Asset Pricing Model). A company that possesses a higher beta has greater risk and is also expected to generate higher returns.
All things being equal, a higher beta represents the higher cost of a capital discount rate. A higher discount rate will cause a lower present value placed on the future cash flows of a company. In short, beta impacts the company’s share valuation.
The beta coefficient is interpreted in the following ways:
- β =1 means exactly as volatile as the market (indicates that the price of a security will move according to the market).
- β >1 means more volatile than the market.
- β <1 means less volatile than the market.
- β =0 means uncorrelated with the market.
- β <0 means negatively correlated with the market.
- Beta is used to calculate the volatility of a stock in relation to the market. If the market beta is 1.0, and individual stocks are framed according to how much the stock deviates from the market.
- If stock swings more than the market over the time that has a beta value lies above 1.0. If a stock swings less than the market then the beta value is less than 1.0 of a stock.
- High-beta stocks are more volatile and considered to be riskier and provide the potential for a higher return. Low-beta stocks poses less risk and also provide lower returns.
- If any stock has a Beta value of zero then the movements are not correlated with the movement of a benchmark.
- Beta value can tend to be a negative number which represents that it generally moves in the opposite direction of the benchmark.
The beta of a stock measures of the level of systemic and unsystematic risk of a stock based on the past performance. A beta of an individual stock gives only a theoretical idea to the investors of how much risk is inherent in the stock. For beta calculation, the stock and the benchmark should be related to each other.
Assuming the value of beta the stock is 1.2, it means it is 20 percent more volatile than the market.
High β – If a company has a β which is greater than 1 that is more volatile than the market. An example maybe a fast growing bio- technology company has a β of 1.75 & has returned 17 percent on its shares in a stipulated time period (Beta, however, is usually measured weekly).
Low β – If a company has a β lower than 1, it represents lower volatility than the benchmark. A good example is an electric utility company whose β is 0.45, that would have returned only 4 percent of what the market returned in a particular period of time.
Negative β – Assuming that a company carries a negative β, it means that it is negatively correlated to the market returns. For an example, a metal company having β of -0.2 that would have negative returned i.e. minus (-) 2% when the benchmark rose over 10%.
Few investments challenge the assumptions by offering the lower value of Beta but track a high record for the higher returns than the benchmark.
Advantages of Beta (β)
- In the case of CAPM, beta is a useful tool. The price variability of stock is important to consider while assessing risk. If you have taken the risk as the possibility of losing stock value then beta has provided as a proxy for the risk.
- The price of early-stage technology stocks that fluctuates more than the market. It is not hard to assess that stock would be riskier than a low beta stock of the safe-haven utility industry.
- Besides that, the beta offers a quantifiable, clear measure which gives ease of use. Although, there are variations on the beta values that depend on the market index and the time period.
- It is a convenient measure which is used to calculate the value of the cost of equity for the valuation method.
Disadvantages of Beta (β)
A beta has plenty of disadvantages for investing in a stock’s fundamentals. Few of them are stated as under:
- Beta doesn’t consider new information.
- Another troubling shortcoming is that historical price movements are bad predictors of the future.
- A stock’s beta is merely a rear-view mirror that reflects very less of what lies ahead.
Furthermore, if beta measures on a single stock tend to change around over the time that makes it unreliable. For traders, who look to buy & sell stocks within a short period of time, beta is a good risk metric.
For investors, the selection of a stock by using Beta is a good way to avoid the volatility and a way to create a diversified portfolio. However, Beta is NOT a holistic representation of risk & volatility itself does not mean loss of capital, which in many terms is stronger meaning of risk. Hence, caution must be employed while using this parameter.