To understand Beta, we must first learn what is the risk of a portfolio for investment. A portfolio with many asset for investment will have each asset with their own risk. Combined risk of all these assets in a portfolio is the total risk of holding this portfolio. This portfolio risk needs to be adjusted in such a way that assets having high risk and low risk can offset each other.
Risk in stock market can be classified as:
- Unsystematic Risk
- Systematic Risk
Unsystematic Risk:
This kind of risk arises in a stock due to the influence of internal factors within an organisation or industry as compared to the overall market behaviour. This risk can be controllable and minimized through diversification of portfolio. This risk is also known as diversifiable risk, specific risk, idiosyncratic risk and residual risk. Risks internal to an organisation or industry are liquidity risks (market liquidity risk, funding liquidity risks), operational risk (Employee errors, system failures, fraud, criminal activities etc), credit risk (credit spread risk, default risk, downgrade risk), political risk, legal risk etc.
Systematic Risk:
This risk on a stock arises due to influence of external factors on an organisation. This risk is uncontrollable. This is also called Market Risk or un-diversifiable risk. Risk external to an organisation or specific industry are inflation, interest rate changes, recessions, wars, fluctuation in currencies which influence the direction and volatility of the entire market. Broadly Systematic risk is divided into 3 types, Interest rate risk, market risk and purchasing power risk. This risk affects large numbers of securities and large number of industries in the market. This risk can be minimized through asset allocation, hedging. Assets of different class (bonds, equities, stocks, cash) react differently to external risks. For same factors, some asset might be falling while others going up. Hedging in different markets can reduce the impact of this risk as if one market goes down, investment in the same stock in another market will recover if market perform well.
Beta (β):
Beta is a measure of a stock or a portfolio volatility or Unsystematic Risk as compared to the overall market or a bench mark index. When market is going up(Bullish), the general perception is to invest in high beta stock and when market is bearish, is to invest in low beta stocks. This might not be an efficient investment strategy always.
Calculation of Beta
Beta is calculated by comparing the historical return of an asset with the market return using their covariance.
Beta = [ Covariance (Stock Return, Market Return)]/ Market Variance
Here, Variance is square root of Standard Deviation. Standard Deviation measures the variability of returns from the expected value or volatility.
A benchmark index is one which gives an investor a reference point to check how his invested portfolio is performing. Beta of popular benchmark index such as S&P 500, BSE Sensex, CNX Nifty are treated as 1. When the beta of a stock is >1, then the stock will move more than the market in the same direction. Beta of +1.3 means when stock market move by 1, Beta will increase by 30%. This stock is riskier by 30 % but has an equal potential to be profitable. But if market return goes down by 1, Beta of this stock will go down by 30%. Thus, there will be a loss by 30% more than that of the market loss. When Beta is < 1, when market goes up, Beta goes down and vice versa. Example of negative beta investment is gold.
Beta is used in Capital Asset Pricing Model(CAPM) which measures the return of a stock. The CAPM formula states that, “the expected return of an investment is equal to the return on a risk-free investment plus the risk premium that is applicable, adjusted to the relative risk of the common stock”.