Understanding Beta in Stocks: Formula, Types, Advantages & Disadvantages
Beta helps investors analyse market volatility and prepare for potential risks. It is the key to informed decision making when it comes to investment. High beta values provide insight into high-outcome yet risky stocks whereas low beta stocks present stable, safe opportunities to earn less profit.
Risk is an inevitable part of investing. As threatening as it may sound, a risk could also boost returns. Yes you heard that right, risks are potential opportunities that if you can understand, mitigate and measure, can be very useful. There are two types of risks that investors must be aware of – unsystemic and systemic. While unsystemic risk is diversified and unique to each security, systemic risk refers to the overall market risk and cannot be diversified.
Beta helps investors understand the systemic market risk a particular security holds and is pivotal in portfolio construction. in this blog, we will dive into the different types of beta in stocks, formula and pros and cons. I
What is beta?
Beta (β) is used to determine the volatility of the returns you get from an investment. Volatility measures fluctuations in the value of an asset. Within financial markets, risk and volatility share a close relationship. Volatility can be considered as the precursor or a warning sign of a risk. It is crucial to understand that when the market is so volatile that it changes on a daily basis, the notional value is bound to swing in either direction. In such a scenario, investors use beta as a tool to identify the direction of the price of a security.
Note: Notional value is the total value of an underlying asset within a contract.
How to calculate beta?
Beta can be calculated using regression analysis plotting, wherein you compare a stock’s returns against those of the overall market. For instance, if the stock market index is moving upwards, but the stock price is dipping, an investor can assess the risk through beta values. The formula for beta is as follows –
Re: Return on individual stock
Rm: Return on the overall stock market
Covariance: Impact of changes in stock returns on the changes in the market returns
Variance: How far the market data points spread out from their average value
Classification of beta values
The value that you derive after applying the beta formula tells you a lot about market volatility and risk. Here is how:
Beta value greater than 1 (β>1)
When the beta value is above one, it is called high beta stocks. This means that the stock’s price is more volatile and better-performing compared to the overall market. While investors can earn significant profit, these stocks also have a high risk factor. A drop in the market means stocks will plunge. Usually, small and mid-cap entities within cyclical industries have high beta stocks.
Beta value below 1 (β<1)
A beta value lower than one represents low-risk stocks that perform lower or closer to the overall market. Low beta stocks are an excellent way for investors to ensure steady returns even if they are not as sizeable as high beta stocks. Stocks across sectors like healthcare and utilities are the ones with low betas.
Beta is equal to 1 (β=1)
The most stable and safe stocks are the ones with beta value equal to one. In simple terms, a beta value of one means that the stock is just as risky as the market. Typically, large cap companies showcase stocks with beta equal to one.
Beta is equal to 0 (β=0)
On the other hand, a beta value equivalent to zero means that investment instruments have no risk associated with them. Investors mainly consider this type of a stock to add an element of safety in their portfolio. Fixed deposits, government bonds and cash itself are good examples of these stocks.
Beta is negative (β<0)
Stocks with negative beta values represent movement in the opposite direction of the market. Gold stocks are more likely to have negative betas as these assets prefer a downward market movement. Investors usually invest in these instruments to gain higher returns in times of drastic market fluctuation.
Pros and cons of beta stocks?
Advantages include –
- Helps investors analyse securities before investing
- Helps assess market risk related to company stock
- Indicates the degree of interdependence between two parameters
- High beta stocks can be useful for investors seeking substantial profits
- Low beta stocks can be helpful for investors looking for stable returns
- Helps evaluate the stock’s past performance in line with the market’s historic performance
- Helps forecast the returns on equity
Disadvantages include -
- Past data cannot be fully reliable in predicting the future
- Severe market fluctuations make stocks very volatile and unpredictable
- It does not measure unsystemic risks like company debt and lawsuit
- High beta stocks increase the exposure to high risk
To conclude: Beta is key in the stock market
Beta plays a key role in the stock market. It guides investors, provides valuable insights and helps navigate them. It helps them make important decisions like whether to invest in a particular stock. Investors can also determine the performance of a stock, whether it is higher or lower than the market at a given risk. This helps them understand how the addition of the stock will affect the volatility of their portfolio. Ultimately, investors can themselves perform well and adapt with the changing market conditions.