Beta in Finance

What is Beta in Finance?

Beta, in finance, is measurement of the volatility of an investment in the market relative to other investments.

The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.

Beta measures the responsiveness of a stock’s price to changes in the overall stock market. On comparison of the benchmark index for e.g. NSE Nifty to a particular stock returns, a pattern develops that shows the stock’s openness to the market risk. This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1).

What Does Beta in Finance Mean?

Beta is the measure of an asset’s risk in relation to the market (for example, the S&P500) or to an alternative benchmark or factors. Roughly speaking, a security with a beta of 1.5, will have move, on average, 1.5 times the market return. More precisely, that stock’s excess return (over and above a short-term money market rate) is expected to move 1.5 times the market excess return).

Beta is calculeted by beta coefficient.

According to asset pricing theory, beta represents the type of risk, systematic risk, that cannot be diversified away. When using beta, there are a number of issues that you need to be aware of:

  1. betas may change through time;
  2. betas may be different depending on the direction of the market (i.e. betas may be greater for down moves in the market rather than up moves);
  3. the estimated beta will be biased if the security does not frequently trade;
  4. the beta is not necessarily a complete measure of risk (you may need multiple betas).

Also, note that the beta is a measure of co-movement, not volatility. It is possible for a security to have a zero beta and higher volatility than the market.

Beta is a mathematical measure of the sensitivity of rates of return on a portfolio or a given stock compared with rates of return on the market as a whole. A high beta (greater than 1.0) indicates moderate or high price volatility. A beta of 1.5 forecasts a 1.5% change in the return on an asset for every 1% change in the return on the market. High-beta stocks are best to own in a strong bull market but are worst to own in a bear market.

Example

A new company is offering its stocks to the public and after a while it’s beta indicates that it is highly volatile at 1.44, this means that the stock’s price deviates about 44% from the mean. Most stocks that are derived from technology and are offered through popular exchanges like NASDAQ have higher betas and indicate higher more secure returns on investments. While securities that have lower returns usually have lower betas, like bonds and preferred stocks.

Stocks use benchmarks to determine betas, often large and common indexes are used for this purpose. Things such as government bonds have low bonds but they aren’t zero because they are still affected by the market but are low volatility when compared to other indexes, treasury bonds are hard to find benchmarks for because the stocks other indexes are comprised of don’t resemble government bonds, but the lower the beta the more secure the investment is.

Beta can even be 2 or higher, meaning that on average a stock does twice the performance of the market. Negative betas indicate opposite behavior to the market, so when the market experiences a downturn that security with a negative beta can be expected to climb.

The beta coefficient can be interpreted as follows:

  • β =1 exactly as volatile as the market
  • β >1 more volatile than the market
  • β <1>0 less volatile than the market
  • β =0 uncorrelated to the market
  • β <0 negatively correlated to the market

Examples of beta:

  • High β – A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market returned in a given period (typically measured weekly).
  • Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period.
  • Negative β – A company with a negative β is negatively correlated to the returns of the market. For example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%.

Risk and Beta

Beta investment is used as an indicator of systematic risk, volatility, and market risk. The systematic risk is the risk that is intrinsic to the entire market. It affects the general market and not just a particular stock or industry.

Systematic risk is unpredictable and cannot be completely avoided through diversification. Hedging is a way to minimize this type of risk, which is offsetting one investment against another. Your asset allocation strategy can also help to diminish the systematic risk by apportioning your assets according to your goals, level of risk tolerance, and your time horizon.

There is a possibility that an investment’s actual return will be different from its expected return. Investment beta includes the possibility that you will lose some or all of your original investment amount. Different types of risk can be measured by calculating the standard deviation of the average returns or the previous returns of an investment.

A stock’s price variability should be considered when you are assessing risk. To determine the short-term risk of a stock, use the beta coefficient and the price volatility.

Beta Finance and Types of Risk in Stocks and Portfolios

Beta finance recognizes several levels of risk, including aggressive, moderate, and conservative. Aggressive portfolios carry a high-risk but high-reward proposition. Beta finance for aggressive portfolios means that the stocks tend to have a high beta or sensitivity to the overall market. Higher beta stocks normally experience larger fluctuations as compared to the overall market.

Portfolios that carry a moderate risk have a medium amount of risk and a time horizon of longer than five years. Investors who are more conservative with their portfolios may choose defensive stocks. Stocks that do not have a high beta are fairly insulated from large market movements.

Cyclical stocks are the most sensitive stocks to the underlying economic business cycle. The benefit of purchasing cyclical stocks is that they offer an extra layer of protection against negative events.

Beta investors are normally passive investors. People who use beta finance are normally not looking to outperform the market.

Beta of Stocks

The beta of stocks measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.

For example, if a stock has a beta of 1.5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by 15%. (15% = 1.5 x 10%). If a stock has a beta of .5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by only 5%. (5% = .5 x 10%). If a stock has a beta of -1, and the return on the overall stock market rises by 10%, then the return on that stock is expected to decline by 10%. (-10% = -1 x 10%).

Beta of Portfolio

You can also use beta to measure the volatility of an entire portfolio. The beta of a portfolio is simply a weighted average of the assets within the portfolio.

For example, if 50% of the portfolio is comprised of an asset with a beta of .5, and the other 50% of the portfolio is comprised of an asset with a beta of 2, then the portfolio beta would be 1.25. (1.25 = (.5 x .5) + (.5 x 2)).

Similarly, if 25% of the portfolio is comprised of an asset with a beta of .5 and the other 75% of the portfolio is comprised of an asset with a beta of 2, then the beta of the portfolio would be 1.625. (1.625 = (.25 x .5) + (.75 x 2)).

Beta of Market Portfolio

The beta of market portfolio is always one. Because beta measures the sensitivity of an asset to the movements of the overall market portfolio, and the market portfolio obviously moves precisely with itself, its beta is one.

Benefits and Limitations

Beta can be a good measure of risk for short-term traders who are looking to buy and sell stocks. It can also be useful to help you with properly diversifying the investments in your portfolio.

While beta can be useful, it also has some limitations. Beta leaves out recent information such as new debt or an insufficient price history. It relies on past information, which does not guarantee the continued or stronger future performance of a stock.

The past price fluctuations of a stock are a poor future predictor. Past beta is not a good predictor of future beta. The measurement of beta on a single stock tends to be volatile over time. Finally, it is also not a good choice for long-term investors.