What is beta in stock market and how to identify if a stock is high-beta or low-beta?
In financial terms, beta is a statistical coefficient that measures how sensitive a stock is to market fluctuations. Colloquially, beta stocks refer to stocks that are either highly volatile or frequently see large price movements.
What is beta in the stock market?
In the stock market, beta is a measure of a stock's volatility in relation to the overall market. A benchmark, such as the Nifty, is often assigned a beta value of 1. You can evaluate other stocks based on their relative movement to the Nifty or any other benchmark. The aim is to determine if they are relatively more or less volatile.
To calculate a stock's beta, you can divide the covariance of its return by the return of the benchmark. Then, divide this resulting amount by the variance of the benchmark's return over a specified time period. As a side note, covariance measures changes in a stock’s return in relation to the changes in the benchmark’s return.
Variance measures how far the benchmark’s data points are spread out from their average value.
Beta (β) = covariance/variance
Beta is a dynamic figure and changes with time.
The beta coefficient can be interpreted as follows:
β = 1
If the beta of a stock is exactly 1, it means the stock or security is exactly as volatile as the benchmark. For instance, if the benchmark moves up by 1 percent, you can expect the stock also to move up by 1 percent.
β > 1
A beta higher than 1 means the stock is more volatile than the benchmark. Such a stock tends to move by a greater amount compared to the benchmark. For example, let’s assume a stock's beta is 2.5. Now, if the benchmark moves up by 1 percent, the stock is likely to move up by 2.5 percent. When market participants talk about high beta stocks, they usually refer to stocks with a beta value greater than 1.
1 > β >0
Stocks with a beta of under 1 are relatively less volatile than the benchmark. For example, if the beta of a stock is 0.5, the stock will move 1 percent for every 2 percent move in the benchmark. Due to low volatility, low-beta stocks are considered relatively safer than other stocks in the market.
β = 0
A beta reading of 0 signifies no correlation to the benchmark. If the benchmark is, say, Nifty, securities such as government bonds will have little or no correlation to it. In such cases, the beta value is zero. As a result, the movement of such assets in connection to the movement of the benchmark cannot be determined. Stocks rarely have a beta value of zero.
β < 0
A negative beta indicates an inverse relationship with the benchmark. For example, if a stock's beta value is minus 1.5, it will fall by 1.5 percent for every one percent increase in the benchmark, and vice versa. Contrarian traders can take advantage of such stock in a market downturn as during that time they tend to perform better than the market.
Who should invest in beta stocks?
Beta is a value that determines the risk and reward associated with a stock. Every trader or investor can use this reading in their trading strategy. High beta stocks, that is, those with a beta value of more than 1, are more suitable for those who can take more risks. The reward associated with such stocks can also be higher.
On the other hand, conservative investors or traders should stick to low-beta stocks since it will be easier for them to manage the volatility of their portfolios. However, low-beta stocks may also offer moderate returns compared to high-beta stocks.
Advantages and limitations of beta in the stock market
Beta can inform you of the risks associated with stock and prepare you for its associated volatility. A beta reading also foretells how much reward you can expect if the market is constantly moving in the same direction.
The biggest drawback is that beta is a measure of a stock's past performance. In other words, the stock may not continue to move in the same proportion as it has in the past. As a result, the beta value of a stock may fluctuate over time and could make any estimates made prior to investing, null and void.
Q. What should be the ideal beta for a stock?
The beta of a stock depends on its past price movement. While there is no ideal level, the beta should typically correspond to how much risk you can take.
Q. Should I look for beta before investing?
If you are a long-term or value investor, the beta of a stock should not bother you as much. What you should focus on is how much value a stock can create for you over the longer run. However, beta can help give a broad sense of what to expect from a stock.
Q. What is the range of beta?
Beta is a relative term that is expressed assuming the benchmark’s beta is set at 1. Beta value can be any number and can be either positive or negative.
What is a share market? It is a marketplace where buyers and sellers come together to trade shares or stocks, which represent ownership in companies.