Monday, April 7, 2014

Beta

Beta is a numeric value that measures the fluctuations of a stock to changes in the overall stock market. A measure of a security's or portfolio's volatility. It also measures the responsiveness of a stock's price to changes in the overall stock market.

The degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationships with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market returns. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good reflector of the market.

Beta is a measure of an investment's relative volatility. The higher the beta, the more sharply the value of the investment can be expected to fluctuate in relation to a market index. Beta is calculated by using regression analysis; one should think of beta as the tendency of a security's returns to respond to swings in the market.

A beta of 1 indicates that the price of a security or portfolio will move in tandem with the market, or further can be termed as neither more nor less volatile or risky than the wider market. A beta of more than 1 indicates greater volatility and a beta of less than 1 indicates less volatile than the market.

Beta is an important component of the Capital Asset Pricing Model, which attempts to use volatility and risk to estimate expected returns.

Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected.

Risks can be classified as Systematic risks and Unsystematic risks.

  • Unsystematic risks:
    These are risks that are unique to a firm or industry. Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio. 
  • Systematic risks:
    These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio.
For example, if a stock's beta is 1.2, theoretically, it's 20% more volatile than the market. Many utilities stocks have a beta less than 1. Conversely, most high-flying tech stocks have a beta greater than 1, offering a chance for higher returns but with far greater risk.

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).

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