Beta is an important term related to investment and finance. The Beta for an investment is a number that describes the correlated volatility of an asset with the volatility of a benchmark that an asset is to being compared. The ideal benchmark has a beta of 1.0. Investments are compared to the benchmark as per the level of deviation occurs from the benchmark.
Generally, the S&P 500 stock index used as the “benchmark” for measuring the risk of other investments in order to get the idea of what to expect.
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 possesses a higher beta has the greater risk and also maximum expected returns.
Beta is one of the key components for the CAPM model that calculates the cost of equity. The cost of capital is a discount rate used to represent the present value of future cash flows of a company.
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.
Beta is calculated by the regression analysis and beta is taken as a tendency of the securities returns that behave to swings in the market.
The beta coefficient is interpreted in the following ways:
- β =1 means exact 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>0 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 or beta coefficient 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 an idea to the investors theoretically how much the risk will add in the stock. For beta calculation, the stock and the benchmark should be and should be related to each other.
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The selection of a stock by using beta is a certain way to avoid the volatility and a way to manage a diversified portfolio.
Assuming the value of beta the stock is 1.2 and theoretically, 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. As an example, any high-risk technology company has a β of 1.75 & returned 17 percent of what the market returns in a stipulated time period (typically measured weekly).
Low β – If a company with a β is lower than 1 that represents less volatile than the entire market. For example, by considering an electric utility company whose β is 0.45 that would have returned only 4 percent of what the market returned in a predetermined 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 market raised at 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, a beta is the 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 those traders who are looking to buy & sell stocks within a short period of time then beta is a good risk metric. However, for investors who invest in a long-term horizon, it is less useful.