Beta β is a measure of the systematic risk of security that cannot be avoided through diversification. Therefore, Beta measures non-diversifiable risk. It is a relative measure of risk: the risk of an individual stock relative to the market portfolio of all stocks. Beta is a statistical measurement indicating the volatility of a stock’s price relative to the price movement of the overall market. Higher-beta stocks mean greater volatility and are therefore considered to be riskier but are in turn supposed to provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.
The market itself has a beta value of 1; in other words, its movement is exactly equal to itself (a 1:1 ratio). Stocks may have a beta value of less than, equal to, or greater than one. An asset with a beta of 0 means that its price is not at all correlated with the market; that asset is independent. A positive beta means that the asset generally tracks the market. A negative beta shows that the asset inversely follows the market; the asset generally decreases in value if the market goes up.
Higher-beta stocks tend to be more volatile and therefore riskier but provide the potential for higher returns.
Lower-beta stocks pose less risk but generally offer lower returns.
Formula
\(\beta_{IM}=\frac{Cov_{im}}{\sigma _{2}^{m}}\)
\(\beta_{IM}\) = Beta of security with market
\(Cov_{im}\) = Covariance between security and market
\(\sigma _{2}^{m}\) = Variance of market returns
(or)
\(\beta_{IM}=\rho_{im} \frac{\sigma_{i}}{\sigma _{m}}\)
where \(\rho_{im}\) = Coefficient of Correlation between security and market returns
Example: Consider the stock of XY Ltd. which has a beta of 0.85. This essentially points to the fact that based on past trading data, XY Ltd. as a whole has been relatively less volatile as compared to the market as a whole. Its price moves less than the market movement. Suppose Nifty index moves by 1% (up or down), XY Ltd.’s price would move 0.85% (up or down). If XY Ltd. has a Beta of 1.3, it is theoretically 30% more volatile than the market.
Higher-beta stocks tend to be more volatile and therefore riskier but provide the potential for higher returns. Lower-beta stocks pose less risk but generally offer lower returns. This idea has been challenged by some, claiming that data shows little relation between beta and potential returns, or even that lower-beta stocks are both less risky and more profitable.
Beta is an extremely useful tool to consider when building a portfolio. For example, if you are concerned about the markets and want a more conservative portfolio of stocks to ride out the expected market decline, you shall focus on stocks with low betas. On the other hand, if you are extremely bullish on the overall market, you shall focus on high beta stocks in order to leverage the expected strong market conditions.
Beta can also be considered as an indicator of expected return on investment. Given a risk-free rate of 3%, for example, if the market (with a beta of 1) has an expected return of 10%, a stock with a beta of 1.3 should return 12.1% (=3+1.3(10-3)).
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