The beta factor of securities

In the recent days, we witnessed that the markets are widely affected by the macroeconomic factors like inflation, supply chain issues and geo-political tensions because of which stock prices are looking unstable. We have to stay alert while picking stocks. For that we should know how a stock behaves. So, what if there is an indicator to find the sensitivity of stocks in relation to markets? Yes, there is. We can measure the volatility of stocks with the help of a statistical measure called Beta. Here, we are going to discuss about beta, what it indicates, how it can be used and its limitations.

What is Beta? How it is calculated?

There are two types of risk in the market – Systematic Risk and Unsystematic risk. Unsystematic risk is the company specific risk like management inefficiency, fraud, litigation etc., which can be mitigated through Diversification. Whereas systematic risk arises due to macroeconomic factors and cannot be mitigated. Such non-diversifiable risk can be calculated using a statistical measure called Beta. Beta measures the change in return of stock in relation to the change in market return. It can be calculated using:

1. Regression method 

This model postulates that there is linear relationship between stock and market returns and the Beta is the slope of the equation. In this method, we can simply calculate the beta in excel using SLOPE formula where the known variables of X will be historical stock returns and known variable of Y will be historical market returns

2. Correlation method

Correlation measures the extent to which two variables i.e., stock returns and market returns are related. Using this method, the beta can be calculated from historical returns using formula-

β = Correlation Coefficient b/w market and stock return * Std. Deviation of Stock
Std. Deviation of Market Index

In all the below examples w.r.to Indian context, Nifty 50 returns are taken as market returns.

Beta Indicator

It is not important how we calculate beta as it is instantly available in many public domains. The critical part is our understanding of what beta indicates and how to interpret it for decision making.

• A beta of 1.0 indicates that the stock has same risk as that of market i.e., if the market rises by 1%, then price of the stock also increases by 1%. Mostly blue-chip stocks will have beta close to 1. For example, Reliance Industries has a long-term beta of 1.03 which indicates the stock will move in line with market.
• Beta greater than 1 indicates that the stock has above average risk than markets. Tata Motors Stock has a beta of 1.66 which means if market moves up by 5%, then the stock will go up by 8.3% (5% X 1.66) and vice versa.
• A stock with beta less than 1 will have below average market risk and will be less volatile in relation to market. E.g., Asian Paints, Britannia, Dabur has beta ranging between 0.5 to 0.6.
• Negative beta indicates that the security will move on opposite direction in which market moves. It is rare for stocks to have negative beta. But assets like gold may have negative beta as gold is seen as an alternate investment when market falls.

Industry Beta and Portfolio Beta

Industry beta is measured as the average of individual company beta in that industry. IT stocks, early-stage companies, small cap stocks and other cyclical sectors like consumer discretionary and Industrials will have high beta and risk. Whereas defensive sectors like Consumer staples, Health Sector and utilities will have low risk and low beta.

Portfolio beta is the weighted average beta of the securities in the portfolio. In mutual fund, Beta is widely used measure of fund’s performance in relation to that of market.

Using Beta for Decision Making

Primarily, Beta is a measure of risk and is one of the metrics to look into while doing asset allocation. If you are an aggressive investor, you can look for investing in high beta stocks to earn higher returns that that of market while a conservative investor can look for low beta stocks to play on safer side. More than stock beta, industry beta will come in hand for a long-term investor to allocate portfolio between different sectors. Besides, Calculation of beta for alternative investment options like gold, real estate etc., in relation to market return will give clearer picture for our risk allocation. Further, Beta can be used by traders to time the markets by investing in high beta stocks in a bullish market and low beta stocks on a bearish market.

Indices

NSE has designed Nifty High Beta 50 Index and NIFTY Low Volatility 50 Index to measure the performance of high beta stocks and low volatility stocks respectively. As discussed above, FMCG and auto sector tops in low volatile index while high beta index comprises of financial services and metal sectors on top. Here are the top 10 constituents in both the index –

Source: NSE website

Limitations of Beta

As the other side of the coin, Beta also suffers from few limitations. First, it is based on historical data and can only be indicative for the future outlook. Second, it measures systematic risk only and hence company specific risk factors should be considered before making any decision. It is more used as a tool for technical analysis than fundamental analysis.

Conclusion

To conclude, Beta should not be used as distinct factor, rather to be used along with other fundamental tools to identify stocks. Yet, beta is a valuable input in decision making as it standardizes the measure of volatility making it comparable across stocks.

Happy Investing!

Ref: ICAI - CA Final SFM Study Material, NSE website