Beta Coefficient
Beta is a measure of volatility in the share market that evaluates risk according to how the market is moving. It provides a risk analysis of any stock or portfolio you wish to track in the overall market.
Beta, also known as the beta coefficient, tracks the ratio of prior returns of a security or stock to the prior returns of the market. It is primarily used to track the expected returns of an investment in the Capital Asset Pricing Model (CAPM). Beta is an extremely helpful tool for market analysts and investors alike.
What is the beta in the share market?
Beta in the share market is a measure of systematic risk or movement of a portfolio or security compared to the stock market as a whole. The statistical analysis is done by comparing the returns of a particular security to those of the overall market to understand the present risk ratio of the investment in the market.
We have already established that beta is used in the Capital Asset Pricing Model. This is a widely used approach for pricing risky assets or securities and estimating the returns of an investment. If the stock is moving in the same direction as the share market, then you know there is no risk at the moment.
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Systematic vs unsystematic risk
Unsystematic risk can be thought of as a risk that is specific to a particular stock, while systematic risk can be considered as a risk that affects the market in general. When we invest in only one stock, the returns can vary significantly compared to the overall market returns. This difference can be observed by comparing the return of a specific stock to a major stock index. As we add more stocks to our portfolio, the portfolio’s overall returns will start to resemble the returns of the overall market. When we diversify our portfolio, we can reduce unsystematic risk, which is specific to individual stocks.
Systematic risk is a risk that affects the entire market. It is caused by changes in macroeconomic variables such as interest rates, inflation, GDP, or foreign exchange, which impact the overall market and cannot be avoided through diversification. Beta in the share market is used to compare the rate of change between the returns of the overall market and individual stock returns and to assess how much unsystematic risk is associated with systematic risk.
The Capital Asset Pricing Model (CAPM)
CAPM describes the relationship between the general market or systematic risks and expected returns for the investments. It is a financial model that helps you calculate the rate of returns basis a risk analysis using beta. It is a popular method in the market for experts to price risky assets while taking into account the cost of capital and the sensitivity of the market.
How to calculate the beta in share market?
The formula for beta coefficient calculation is -
Beta coefficient(β) = Covariance(Re, Rm) / Variance(Rm)
To break this down, here is what the components of the formula mean:
- Re= Returns on a stock or security
- Rm= Returns on the whole share market
- Covariance= Relation between changes in the market's returns and a stock's returns
- Variance= Distance between the values in the set from the average (or) how far the data is from the mean and other values in the set
For example, if a particular stock or security's value has increased by 10% but the share market's value has increased by only 8%, then the beta coefficient could be determined as 10/8= 1.25.
Advantages of using beta in share market
Beta does provide a great measure of risk and market movement for an investor. It is apt for short-term risk analysis and reflects well on the past data of a stock. Investors who prefer to invest in risk-free assets benefit from the beta in the share market as they can effectively go for options that are systematically moving in line with the stock market.
Disadvantages of using beta in share market
Beta in the share market is not a flawless analysis for determining risk. There are certain disadvantages to this method:
- Beta does not account for the performance, history, or milestones of a company. It is solely dependent on values or numbers for its calculation.
- The measure of beta in the share market keeps changing depending on the returns. Hence, it only works for a short-term analysis.
- An investor can get tangled in only value-trap investments.
- Future movements of a stock cannot be predicted.
Also read: Why is share market down
Summing up
Now that you know all about beta in the share market, it is time to understand how to interpret this data so you can effectively use statistical analysis to trade in the stock market. A beta coefficient of 1 would mean that the stock is moving with the market, and hence, there are no risks to your investment. However, it would also mean there are no profits. A beta of 1.5 would mean that the stock is more volatile than the market. This can be risky but is also likely to generate higher profits for the investor. Similarly, a beta coefficient below 1 would mean the stock is less volatile than the market and not keeping up with the rise.
You can use this data effectively to balance your portfolio and do a risk analysis for your investments. While it is true that beta in the share market does not account for other factors affecting a company's volatility or progress, it can still be considered a good method to compare movement and calculate risks for an investor.
