BAJAJ BROKING
September 26, 2024
4 mins read
Beta is one of the most powerful indicators in the share market. It examines the responsiveness of a stock vis-a-vis the overall market. The market is supposed to have a beta of 1.
If a stock has a higher beta than 1, it is likely to move up and down more than the market. However, if its beta is less than 1, it is expected to move up and down less than the market.
Beta is a measure of the market risk or systematic risk. It can help investors understand the market risk inherent in a stock. Beta can also help them create a diversified portfolio by combining some stocks with more than 1 beta and some stocks with less than 1 beta.
Beta measures how a stock or a portfolio moves vis-à-vis the market. In other words, beta compares the volatility in a stock with that of the market. For the market, we take a benchmark index like Sensex or Nifty.
The market is supposed to have a beta of 1. If a stock has a beta of more than 1, it means that it moves more than the market. However, if a stock has a beta of less than 1, it means that it moves less than the market. If a stock has 1 as its beta, it shows that it moves exactly by as much as the market moves.
Beta is used by analysts and market participants while using the Capital Asset Pricing Model (CAPM) to calculate the estimated returns from a security. Now that we have explained what beta is, let us delve deeper into this topic.
Let us understand the meaning of beta with a few examples. Suppose a stock’s beta is 1.2, it means that it is 20% more volatile than the market. If the market is up by 10%, this stock will be up by 12% [10*(1+20%)]. Conversely, if the market is down by 10%, this stock will be down by 12%.
Most importantly, beta is the measure of systematic risk or market risk. This risk cannot be eliminated by portfolio diversification.
However, you can decide to take more risk than the market, less risk than the market, or the same risk as the market. If a stock’s beta is less than 1, it is less risky than the market. Suppose a stock’s beta is 0.8, it means it is 20% less volatile than the market. If the market moves up by 10%, it will move up by 8%. If the market moves down by 10%, it will fall by 8%.
The formula for beta is as follows:
Beta = Covariance between a stock’s or portfolio’s return with the market’s return / Variance of the market's returns
If you are an investor, you must understand how beta performs in real-market scenarios vis-à-vis theory. In theory, we assume that stock returns are normally distributed. However, when you start trading in the market, you will notice that stock returns are not always normally distributed.
Imagine that a stock has an extremely low beta. It means that it will have smaller price swings compared to the market. But, this stock's price can be declining over a long period of time. Now, if you add this stock to your portfolio, you could incur losses because its price is falling. However, since it has a low beta, it has a lower volatility than the market.
On similar lines, consider a stock with a high beta and a price mostly moving upwards. It can increase your portfolio's risk because it has a high beta. But, it can also help you make a profit because its price is mostly moving upwards.
There can be several types of beta in the stock market, as explained below:
Negative Beta: If a stock has a negative beta, it means that it has an inverse relationship with respect to the market. When the market moves up, it will fall. When the market falls, it will move up.
Zero Beta: If a stock has zero beta, there is no correlation between its price and the market. Whether the market goes up or down, this stock’s price is not expected to change based on the market.
0<Beta<1: If a stock has less than one but more than 0 beta, it means that it moves in the direction of the market; however, it moves lesser than the market. For example, if a stock has 0.7 beta, it will move up by 7% when the market moves up by 10%. When the market moves down by 10%, it will move down by 7%.
Beta = 1: If a stock’s beta is 1, then it will move up and down by exactly how much the market is moving up and down.
Beta>1: If a stock’s beta is more than one, it will move in the direction of the market. However, it will move more than the market. For example, if a stock has 1.4 beta, then when the market moves up by 10%, it will move up by 14%. When the market moves down by 10%, it will fall by 14%.
Beta helps you assess the risk inherent in a stock. Once you have assessed the beta of several stocks, you can diversify your portfolio. For example, you can create a portfolio comprising a few stocks with a beta higher than 1 and a few stocks with a beta less than 1.
Beta also helps you estimate the expected return from a security by using the CAPM model. As per this model, the expected return from a security can be measured by using this equation:
Expected return from a security = Risk-Free Rate + β×(Market Return−Risk-Free Rate)
Let us compare beta with other popular risk metrics in the stock market. As we already said, beta compares the volatility of a stock with that of the market. It shows the risk inherent in a stock due to the market. Hence, beta is a measure of market risk or systematic risk.
On the other hand, standard deviation measures the spread of an asset’s returns over its average returns. Standard deviation does not compare the return of a stock with that of the market. But, it is a good measure for comparing the volatility of stock with that of other stocks.
Then, we also have Sharpe Ratio, which measures the return earned for every unit of risk undertaken by owning a stock. This is calculated by dividing the difference between the return on a stock and risk-free rate with the standard deviation of that stock. Sharpe Ratio combines the risk and return of a stock in one number, which is its strength. However, like beta, it assumes that a stock’s returns are normally distributed, which may not be the case always.
Beta assumes that a stock’s returns are normally distributed, which may not be the case in the real market. When a stock’s returns are not normally distributed, beta may not be applicable to assess its risk.
Moreover, beta is based on past data. While using beta, we assume that past data will accurately reflect the future, which may not be the case. In other words, beta does not remain constant over time.
Let us take the case of a start-up, which will take a few years to mature. When it is in the start-up stage, its performance will significantly vary. Hence, its stock price will be highly volatile. Therefore, it will have a high beta. However, once it becomes a mature company, its stock price and performance may stabilise. Hence, its beta may decline. So, for such a company, we may find it difficult to use beta based on past data.
Over many decades, beta has emerged as a powerful measure for stock trading, portfolio management, and option trading. By comparing a stock’s volatility with the market, it provides compelling insights to investors. However, it has limitations as well. For example, it assumes that an asset’s returns are normally distributed, which may not be the case always. Therefore, investors should be aware of the strengths and limitations of beta while using it.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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There is nothing called a good or a bad beta. Beta depends upon an investor’s risk tolerance level. If you are risk-averse, you should pick stocks with less than 1 beta. However, if you can take risk, you should select stocks with more than 1 beta.
A stock with 1.5 beta is likely to move up by 15% when the market moves up by 10%. And when the market moves down by 10%, it is likely to fall by 15%. In short, such a stock will move 50% more than the market.
Beta less than 1 is good for risk averse investors. A stock with less than 1 beta will move up by a lower percentage than the market and will move down by a lower percentage than the market. However, beta less than 1 is not good for investors who can take high risk.
When a stock has a β of 1.3, it means that it is likely to move 30% more up than the market when the market moves up. And, when the market moves down, it is likely to move down by more than 30%.
In the share market, beta reflects how much a stock or a portfolio is likely to move up or down based on the changes in the overall market.
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