Wouldn’t it be great if investors could predict how risky a stock is before they could buy it? Naturally, one would only invest in equities that would suit their risk tolerance and limit their losses. Well, there is such an indicator that can signal how volatile the price is compared with the benchmark index – it is called beta.
Let’s understand what is beta in the stock market, its meaning, advantages and more.
This article covers:
- What is beta in a stock?
- How beta is determined in the stock market?
- Beta values for Indian stocks
- Why should you invest in beta stocks?
- Merits of beta stocks
- Demerits of beta stocks
What is beta in stock?
Beta is a statistical measure of a stock’s volatility that may in turn be used to determine how volatile a stock is in comparison to the rest of the market. In other words, the stock’s beta value suggests the extent of its volatility and measures the responsiveness of a stock’s price to changes in the market.
Beta is calculated with regression analysis – a statistical method that measures the relationship of a dependent variable with one or more independent variables. In the case of high beta equities, the stock’s risk is a dependent variable, while the broader market’s volatility is an independent variable.
How beta is determined in the stock market?
Some stocks are highly volatile, while others are not as much. Simply put, beta is the coefficient of a stock variation that indicates the rate at which the value of security changes in response to market movements.
To calculate beta, the formula is as follows:
Beta coefficient (β) = Covariance of a stock / Variance
Covariance is how changes in a stock’s returns are related to changes in the market’s returns.
Variance is how far the market’s data points spread out from their average value
In theory, the beta value of a benchmark index is considered to be 1, and the risk factor of securities is measured around this number. Typically, a stock having a beta coefficient higher than 1 is deemed to be risky. Such a value indicates the possibility of high fluctuations in the corresponding share.
Usually, when the stock market is booming, the high beta stocks generate substantial profit. Conversely, a fall in the value of the benchmark adversely affects beta stocks.
Beta values of Indian stocks
Beta values are primarily of four types. They are different among securities, as well as respective benchmark index depending on which it is calculated.
A beta value greater than 1 indicates that the stock has a high degree of responsiveness in the market. Such shares usually deliver substantial returns on total investment. Examples include securities issued by small and mid-cap companies.
However, stocks with a beta value of more than 1 also have a high-risk factor and remain susceptible to market volatility. As a result, a down-swing in the stock market impacts such stocks significantly.
Indian stocks with a beta value of less than one indicate relative stability and signifies lower volatility. Such stocks fall less than the index in a bearish market. Investment in such stocks is relatively secure, as the fluctuation of returns is not primarily affected by stock market variations.
Such securities have a parallel effect on the share price and its ROE compared to a benchmark index. Being the primary constituent of major benchmark indices in the country, large-cap companies generally have a beta value of 1.
Investment tools that carry no associated risks have a beta value of 0. Such securities are ideal if you want to invest for the protection of capital. Some examples of this type include government bonds, fixed deposits, cash, and so on.
Besides these common four, there exists a unique beta.
Securities that have an inverse relation with the stock market carry negative beta coefficients. When the market crashes or in events of drastic stock market fluctuations, investors often pool their money in such securities for higher returns.
A popular example of an investment tool that has negative beta is Gold. It acts as a hedge against inflation and is also a secure tool for investment.
Why should you invest in beta stocks?
To gain substantial returns on the portfolio, individuals with a high aptitude for risk can invest in stocks with a beta value higher than 1. Stocks of small-cap and mid-cap companies usually have a beta value higher than 1, owing to their potential for growth. Furthermore, if you invest in their bonds, you can also enjoy returns through dividend pay-outs or capital gains through a resale.
One can generate wealth by investing in stocks that have a beta value of 1 like the stocks of large-cap companies. As these companies have a requisite financial base to handle the downswing of the business cycle, there is an assurance that no drastic fluctuation will occur in the stock price.
To have a relatively stable investment venture for risk-averse investors, investing in stock beta less than 1 may be more suited.
Merits of beta stocks
Investors rely heavily upon beta value before investing. It is one of the most significant coefficients that help you analyse the unsystematic or market-related risks of a company, thus helping to gauge the overall risk factor associated with respective securities.
Since beta relies on past data, the beta value of a stock is a good indicator of the stock’s past performance through comparison with a benchmark index; although this does not mean that the same trend would follow in the coming future, you can anticipate returns on equity on the total amount pooled into such securities.
Usually, fixed return instruments are associated with beta value, as returns of respective instruments are not directly affected by stock market fluctuations.
Demerits of beta stocks
Beta value cannot comprehend the underlying performance of the stock issuing companies. Therefore, you can run the risk of investing in value-trap securities if you pool your money based only on the beta in the share market.
Stock investments are risky but using tools and various indicators, the inherent can be effectively countered. Beta value of stocks is one such vital tool to consider before investing in any stock. Although it is not an all-inclusive value, the beta will help you analyse the market risk associated with an instrument and its effect on respective returns generated.