Simplifying stock Beta

It is a well-known fact that equity investments always come with some amount of risk, be it low, moderate, or high. There also exists a general assumption which states that high risks translate to high returns and vice versa. But what exactly is risk? And more importantly, how exactly does one quantify or measure the risk associated with a stock? A term known as Beta, represented by a Greek alphabet is helpful in determining risk and in this article, we will simplify the stock beta.

What’s Beta?

Let’s start by defining the term Beta. Beta is a statistical measure which is used to measure a stock’s volatility in relation to the overall market. The market here is usually an index, like Sensex or Nifty, and the beta of the market is assumed to be 1.0, by definition. So, if a stock fluctuates more than the market in the same direction, the stock has a beta greater than + 1.0. And if a stock fluctuates less as compared to the market in the same direction, then the stock has a beta in between 0 and + 1.0. If a stock beta is less than zero, it will move in the opposite direction of the market. Stocks with higher levels of beta hold a higher return potential and are supposed to be riskier, and stocks with lower levels of beta pose low risks and also lower returns.

Beta is also a component of the Capital Asset Pricing Model, or CAPM which is used for estimating expected returns of assets.

Apart from calculating the beta for an individual stock, one can also calculate the beta for one’s stock portfolio as well. Firstly, one needs to calculate the beta value for each individual stock in one’s portfolio. Then one needs to determine the weight of each stock in the entire portfolio. One can then multiply the two values, the beta of each stock with their respective weight and sum it together to get the beta of the entire portfolio. As an example, assume that one has a PQR stock with beta value of 1.43 occupying 25% of the entire portfolio, so the weighted beta for the stock PQR will be 0.25 multiplied by 1.43, giving 0.3575. Subsequently, one will perform this calculation for all stocks in the portfolio and add up the resultant values and obtain the overall weighted beta, which would then represent the volatility of the portfolio as compared to that of the benchmark against which it is being measured. So, if the weighted beta of the portfolio is 1.04 and the beta of the index which is assumed to be 1.0, then it can be said that the volatility of the portfolio is pretty much in line with that of the index.

Beta value and their implications

Let’s now go through the various types of beta values and their implications.

A beta value equal to +1.0 implies that the stock is strongly positively correlated with the index. This means that if one adds a stock with beta equal to 1 to a portfolio, neither does it add any risk nor does it increase the probability of the portfolio giving higher returns.

A beta value in between 0 and + 1.0 implies that the stock is less volatile than the market. This means that adding this stock to one’s portfolio will potentially reduce the risk as well as the returns associated with the portfolio as compared to the same portfolio without this stock.

A beta value greater than + 1.0 implies that the stock is more volatile than the market. Such a value indicates that if one adds this stock to their portfolio then the risk associated with the portfolio will increase along with a potential increase in the expected returns.

A beta value less than zero has a negative correlation with the market and the portfolio may perform better in the falling market.

How to use Beta to select a stock or create a stock portfolio?

Let’s now look at how one may make use of beta to select either an individual stock or an entire portfolio.

Let’s start with how one may use beta to select individual stocks in their portfolio. Selection of stocks using beta majorly hinges on the risk appetite of the investor. If the individual is particularly risk averse, he or she may create a portfolio by investing in stocks having beta values between 0 and 1 as such portfolios tend to be less volatile than the market and consequently also deliver lower returns. On the other hand, if an individual has higher risk appetite, he or she may create a portfolio by investing in stocks having beta values higher than 1, as such portfolios may deliver higher returns as compared to the market but come with higher volatility, and consequently higher risk.

One can also have their portfolio composed of a mix of stocks having beta values of both less than 1.0 and greater than 1.0, so that on average, the beta of the entire portfolio is close to 1.0.

Drawbacks of considering Beta

One should also keep in mind some drawbacks of considering beta. Generally past price movements are not reliable indicators of future price movements, and since the calculation of beta for a particular stock incorporates historical price points, the resultant beta values may not be a good indicator of future price movement. On top of this, the stock’s volatility may also change significantly year on year, depending upon factors like economic outlook, growth. So, beta is generally thought of as a useful tool in evaluating a stock’s short-term risk, but due to the factors we discussed above, it tends to perform poorly for analysing long-term price fluctuations.

Conclusion

To conclude, we can say that beta is a useful tool in assessing the volatility associated with a stock as compared to an index and can be used to either select stocks or compose entire portfolios depending upon an investors risk-appetite, but one should also keep in mind that beta tends to be not so useful in predicting future price values of a stock.

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