What is Beta of Stock / Security?
Whether a person is an experienced investor or just someone who is trying to put some money away for retirement, knowing the stock beta in relationship to the current market conditions can minimize risk and increase profitability from investments.
The beta (β) of a stock or portfolio tells us the response of the stock to the changes in stock market. To put this differently, Beta value is a measure of a stock’s volatility with respect to market volatility. It is a popular indicator used by many traders and investors to facilitate their trades. Beta is expressed by taking the market volatility 1, and beta values of a stock are calculated as a measure of how much the stock price moved from this market volatility.
Other definitions of Beta:
· The beta (β) of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole.
· Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic risk, or market risk
Thus, Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement.
In a sustained advancing market, generally a stock that is outperforming the whole market would have a beta greater than 1.
Types of Beta:
- A zero beta means that the asset is independent and is no way influenced by the market.
- A positive beta means that the asset generally follows the market.
- A negative beta shows that the asset inversely follows the market.
Types of Beta - In Detail:
1. Zero Beta Securities: This means the value of the stock stays same irrespective of market movement. This is a rare situation. Some zero-beta securities are risk-free, such as treasury bonds and cash. However, simply because a beta is zero does NOT mean that it is risk free. A beta can be zero simply because the correlation between that item and the market is zero
2. Positive Beta Securities:
Beta between 0 and 1 - This means the stock price swing less compared to market movements. Many blue chip company stocks and high-liquidity stocks have beta less than one. In a long-term prospective these stocks fall under low-risk low-profit category.
Beta of 1 - This means the stock price moves in the same relation with the market.
Beta greater than 1 - This means the stock price swings more compared to market movements. Many growing companies and technology companies have beta greater than one. Most of these stocks fall under high-return high-risk category. Also remember, beta at very high levels probably indicates high price volatility because of low-liquidity.
3. Negative Beta Securities: A negative beta simply means that the stock is inversely correlated with the market. Many precious metals and precious-metal-related stocks are beta-negative as their value tends to increase when the general market is down and vice versa.
Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.
Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate cost of equity.
Cost of capital represents the discount rate used to arrive at the present value of a company's future cash flows. All things being equal, the higher a company's beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company's future cash flows. In short, beta can impact a company's share valuation.
The beta coefficient is a key parameter in the capital asset pricing model (CAPM).It measures that part of the risk attached with the asset under evaluation which cannot be diversified. Technically, this is also called as systematic risk or market risk.
If we consider a portfolio with only one investment, beta measurement gives the volatility of the investment / asset. However from the portfolio management point of view, which involves measuring beta for a portfolio containing more than one security, is a separate skill which involves assigning weights to the individual security and so on where they should also consider the risk appetite of the investor.
This is one of the important factors which trader’s generally consider before selecting the stocks. The decision will depend upon the risk appetite of the traders.
In the recent past, most of the analysts were focusing on low beta stocks as the markets were very volatile and they have no clues on the way the markets will move.
Calculation / Measurement of Beta:
Beta can be estimated for individual companies using regression analysis against a stock market index.
The formula for stock beta calculation is:
Beta = Covariance (stock versus market returns) / Variance of the Stock Market
How to Use Beta?
Investors can find the best use of the beta ratio in short-term decision-making, where price volatility is important. If you are planning to buy and sell within a short period, beta is a good measure of risk.
However, as a single predictor of risk for a long-term investor, the beta has too many flaws. Careful consideration of a company’s fundamentals will give you a much better picture of the potential long-term risk.
Cautions while using Beta:
Since beta is a result of regression of one stock against the market where it is quoted, betas from different countries are not comparable.
Beta also doesn’t account for changes that are in the works, such as new lines of business.
The most important rule for using beta to make investment decisions is that beta is a historical measure of a stock's volatility. Past beta figures or historical volatility does not necessarily predict future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee that in a year the beta will be the same.
The stock's variability is measured in relation to the variability of the overall stock market. If the beta measurement is just about one, this means that the stock will move up and down at about the same rate as the overall market. So if the market drops 2% on a particular day, then the stock will probably drop about 2% on the same day. If the beta measurement of a stock is 2, then if the stock market drops 2%, then this particular stock will drop about 4%. This stock is considered to have greater risk than other stocks. While a person can potentially lose a lot of money on it, it also will probably have a greater yield on his / her investment.
If the beta measurement of a stock is 0.5, then if the stock market drops 4% on one day, then this stock will probably drop about 2%. The investor’s money will probably be safer with this stock. However, the return on investment will not be as immediately high as on a stock with a higher beta measurement. If the investors are more of a long term investment style, then beta measurement don't really mean all that much to them. However, if investors are interested in growth investment style, or in working with high yield stocks, then beta measurement can be very important.
Beta is helpful in determining the likelihood of price swings in the near term, but not reliable when looking at the long-term picture. Also, the investor should not get confused with the stock price movement in relation to the movement in market and the financial performance of the company. In the long term, it’s the financial performance of the company which matters but not the Beta. Beta only takes into account the effects of market-wide risks on the stock. The other risks the company faces are firm-specific risks, which are not grasped fully in the beta measure.
So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks the company alone faces.
CA. Venkat Rao Marella.