What is “beta”?

August 30, 2021

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3 min read

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Origins

Beta refers to a numeric coefficient that measures the volatility or fluctuations of a stock’s price in relation to the changes in the overall market. It is also referred to as an asset’s systematic risk, market risk or hedge ratio. A stock’s volatility is the amount of uncertainty related to the size of changes in the stock’s value. When volatility is high, the stock’s value is spread out over a higher range. Generally, the S&P 500 benchmark of 1 is used to calculate the beta. 

A beta above 1.0 indicates a high beta security that moves more than the market, whereas a beta below 1.0 indicates a security that moves less than the market. For example, a beta of 1.3 indicates an asset that is 30% more volatile than the market, and a beta of 0.80 indicates an asset that is 20% less volatile than the market. High-beta stocks provide great return potential, but are also very risky in the case of downswing of the shares market. Conversely, low-beta stocks provide lesser returns in times of market boom, but are also less risky.

Small-cap and mid-cap companies with enormous growth potential tend to have a higher beta, whereas treasury bills and defensive stocks such as healthcare tend to have a lower beta. Large-cap companies tend to have a beta of 1, where the security moves at the same rate as the market. This is because such companies are generally the primary components of the market indices of a country. Though returns are not high, the stability and high-value dividend payouts creates wealth for shareholders. While most securities have a beta between 0 and 3, some assets such as gold miners and inverse ETFs have a negative beta (securities which move upwards when the market goes down). 

How to Calculate Beta

The formula for calculating a stock’s beta is the covariance of the stock’s return with the return of the benchmark, divided by the variance of the return of the benchmark over a certain period. Numerically, it represents the tendency of a stock to respond to changes in the market.

Overview

Beta is a straightforward, clear and quantifiable measure that indicates the price variability of an asset and is therefore useful in determining its portfolio of risk, which helps investors make their decisions. Beta is also useful in determining a stock’s short-term risk and for analysing volatility to arrive at equity costs. 

However, beta is an ineffective measure of a stock’s future movements, since it is based on the stock’s price history. It is also difficult to make long-term investments based on a stock’s beta. While high betas may indicate price volatility in the short term, they do not rule out long-term investment opportunities, which are influenced by big-picture risk factors (such as leadership, assets and liabilities, revenue) which are not included in a beta. Past price movements are also a poor indicator of the future, especially considering that many new technology stocks have insufficient price history to establish a reliable beta. Since beta does not differentiate between upside and downside price movements, it is not very useful for investors, as a high beta implies both risk and great opportunity. Beta is thus not necessarily a complete measure of risk, and investors run the risk of investing in value trap securities if they depend solely on the beta.

Verdict

Beta is also only a measure of co-movement, and not volatility. It is possible for a stock to have zero beta and greater volatility than the market. High beta also does not always mean greater returns. Research indicates that low beta stocks tend to earn higher risk-adjusted returns than high-beta stocks, due to various investment biases and factors unaccounted for by betas.

As a result, while beta is a useful factor in determining a stock’s price risk, it must be used in tandem with other factors, especially for long-term investments.

Report written by Roshni Suresh Babu

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