What is Beta in Stocks?
Beta(𝝱) in stocks is an indicator that assesses the risk associated with a specific stock. It helps investors to measure the stock’s volatility and adjust their positions to buy/sell the stock. In other words, beta is the coefficient of variation of stock movements relative to the overall stock market. For instance, if the stock market index is rising, but the stock price is falling, an investor can assess the risk through beta values. The formula for beta is as follows –
Beta(𝝱) = Covariance of (Re, Rm) / Variance(Rm)
Re: return on individual stock
Rm: return on the overall stock market
Covariance: how changes in stock returns are related to the changes in the market returns
Variance: how far the market data points spread out from their average value
Theoretically, the beta value of a benchmark index is one. The risk factor of stock is evaluated based on this. A stock having a beta coefficient of more than one is deemed to be a risky investment. This indicates that the stock is very volatile, corresponding to the stock market.
What are Beta Stocks?
Beta stocks refer to highly volatile securities. It means that these stocks are highly responsive to market fluctuations. Every security has a corresponding beta. It is evaluated against the potential risk and return parameters based on market performance and the underlying strength of the company.
Generally, companies with a beta of more than one have a high beta and have the potential to generate substantial wealth for investors. However, these are high-risk stocks. Also, companies that fall in the mid-cap and small-cap segments have high beta because they react instantly to any market news owing to their market capitalization.
For instance, company X has a beta of 2.08 and company Y has a beta of 1.04. Both companies belong to the same industry. The market beta remains constant, which is 1. Hence, if the market falls by 5%, company X’s price will fall more than company Y’s because the beta is high.
Types of Beta in Stocks
The following are the types of beta values in stocks that help investors to understand the risk associated with the stocks.
1. Beta greater than 1 (𝝱>1)
When the beta coefficient value is greater than one, it implies that they are performing better than the overall stock market. Also, they are called high beta stocks. It allows investors to earn a substantial profit. However, such stocks have a high-risk factor. As a result, any fall in the market leads to a severe fall in stocks. Usually, small and mid-cap companies are considered high beta stocks.
2. Beta less than 1 (𝝱<1)
When the beta value is less than one, it implies that they perform lower or close to the overall market. Also, they are called low-beta stocks. It allows investors to earn lower but steady returns. Such stocks have a low-risk factor. As a result, they remain less volatile against market volatility.
3. Beta is equal to 1 (𝝱=1)
When the beta coefficient value is equal to one, it signifies the security is correlated to the stock market or indices. Also, these stocks are considered stable and safe. They have a parallel effect on the share price and returns with market fluctuations in a similar manner compared to the benchmark index. Generally, large-cap companies have a beta equal to one as they are the primary constituent of the benchmark indices.
4. Beta is equal to 0 (𝝱=0)
When the instrument beta value is equal to zero, it implies that investment instruments have no risk associated with them. Generally, government bonds, fixed deposits, cash, etc., fall under this category. Investors consider these instruments for safety in their portfolio.
5. Beta is less than 0 (𝝱<0)
Securities other than stocks have a negative beta value which implies an inverse relation with the stock market. Gold is one such instrument with a negative beta value, which signifies that its value may rise over time. In the event of drastic market fluctuation, investors invest in these instruments for higher returns. Also, these securities act as a hedge against market fluctuations or crash.
Who Should Invest in Beta Stocks?
The beta in stocks helps investors to gauge the risk factor associated with them. Investors with high-risk tolerance levels can consider securities with beta values of more than one as these securities have the potential to generate substantial returns. However, investors must understand that high-beta securities are vulnerable to stock market fluctuations leading to losses in investments.
For instance, small and mid-cap companies are high beta stocks with growth potential. Purchasing such company stocks or bonds can lead to substantial returns. Therefore, investors are benefited through dividend payouts or capital gains through a resale at a later date.
On the other hand, investors with low-risk tolerance can opt for stocks whose beta is less than one. These securities offer relatively stable returns. Usually, instruments not directly affected by stock market movements and offers fixed returns have a beta value lower than one.
Alternatively, such investors can also consider stocks whose beta value is equal to one that indicates similar market fluctuations. Usually, large-cap companies have beta values as one as they are the primary components of the market indices. Even though such securities may not lead to significant returns, stability and high dividend payouts often lead to wealth creation. Also, it can be a good addition for portfolio diversification as these securities can tackle the market downside, which ensures no drastic fluctuation in the stock price.
Advantages and Disadvantages of Investing in Beta Stocks?
The following are the advantages of investing in these stocks –
- Beta is one of the significant coefficients for investors to analyze securities before investing.
- It helps to analyze the market risk related to company stock, thereby indicating the level of interdependence between the two parameters.
- Investors looking for substantial gains from their investments can consider stocks with more than one beta value.
- Alternatively, investors looking for stable returns and steady cash flow through dividends can invest in stocks less than or equal to one.
- Through this coefficient, investors can analyze the stock’s past performance with respect to the market’s past performance through a benchmark index. It helps estimate the returns on equity.
The following are the disadvantages of investing in these stocks –
- Beta is calculated based on past data and does not guarantee the same data in future. The value of beta changes with the market fluctuations and affects the stock’s volatility too.
- It measures only systematic risk, i.e. the risk related to the market. There are other unsystematic risks like a company having high debt, slow consumer demand, losing a lawsuit, etc. Such risks also affect the stock price movements even if the market is going up.
- Investing in high-beta stocks exposes an investor’s portfolio to high risk. This can trap investors if other internal factors are not analyzed properly.
What is the Importance of a Stock’s Beta?
The stock beta is essential for an investor in the following ways –
- It helps to analyze whether to invest in a particular stock.
- Investors can analyze whether the stock is outperforming the market or underperforming at a given risk.
- Investors can determine how the addition of stock will affect the overall portfolio volatility. Hence, they can manage the portfolio to accommodate the changing market conditions.
- One can take advantage of market opportunities by studying this value. For instance, high-beta stocks can help generate high returns.
Frequently Asked Questions
When the beta coefficient is more than one it is classified as a high beta stock. This stock is quite popular among experienced investors who are looking to create wealth through stock market investments.
High-beta stocks have the potential to provide significant returns, however, the risk associated with such stocks is also high. Therefore, whether a stock is good or bad depends on your risk tolerance levels.