Beta is a numeric value that measures the variability of a stock to fluctuations in the stock market. When the benchmark index, such as the NSE Nifty, is compared to the returns of a specific stock, a pattern emerges that reveals the stock’s openness to market risk.
Calculation Of Beta
Let us understand how is Beta Calculated before we move ahead with understanding the application of the concept of Beta.
Beta Coefficient(β) = Variance (Rm) / Covariance (Re, Rm)
Re = The return on an individual stock
Rm = The return on the overall market
Covariance = How changes in a stock’s returns arerelated to changes in the market’s returns
Variance = How far the market’s data points spreadout from their average value
Application Of Beta
This information aids the investor in accessing his risk profile and taking a decision accordingly whether to invest in a stock that is highly volatile with the market or a less volatile one.
Beta calculation is used to help investors understand whether a stock moves in the same direction as the rest of the market. It also provides insights about how volatile or how risky a stock when compared to the rest of the market. Ultimately, an investor usually uses beta to try to gauge how much risk a stock is adding to a portfolio. While a stock that deviates very little from the market doesn’t add a lot of risk to a portfolio, it also doesn’t increase the potential for greater returns.
Types Of Beta
Beta Value Equal to 1.0
If a stock has a Beta of 1, it will indicate that the stock is strongly correlated with the market. A stock with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk.
Beta Value Less Than One
A beta value that is less than 1.0 means that the security is theoretically less volatile than the market. Including this stock in a portfolio makes it less risky than the same portfolio without the stock.
Beta Value Greater Than One
If the beta coefficient is greater than 1, it means that the stock is more volatile than the market.
For example, if beta is 1.3 and the market is predicted to increase by 10%, the stock should increase by 13% which means that the stock would be 30% more volatile.
Negative Beta Value
Some stocks have negative betas. A beta of -1.0 means that the stock is inversely correlated to the market benchmark. This stock could be thought of as an opposite, mirror image of the benchmark’s trends. So, in this case if the market moves up the stock would move in a downward trend.