Beta is a metric that compares the movements of stocks (equities or shares) in relation to the overall market, or a certain stock index. It is a measure of volatility for a security or a portfolio in comparison to the market as a whole. It is also called the beta coefficient (β).
| β = |
Covariance of Market Return with Stock Return |
| Variance of Market Return |
Beta is a measure of how sensitive a share price is to movement in the market price. It measures systematic risk, which is the market risk, and represents the likelihood of a security’s returns to respond to swings in the market. A high-beta stock tends to be more volatile than average, while a low-beta stock tends to be less volatile. While it is true that high-beta stocks are typically riskier than the average stock, beta is not necessarily indicative of risk as many people believe.
There are three (3) likely classes a stock can be categorised into based on its beta.
- A stock with a beta less than one (1) suggests that the stock is less volatile than the overall index. For example, a beta of 0.6 suggests that a stock’s movements will theoretically be about 60% of the index’s movements.
- A stock with a beta greater than one (1) suggests that the stock is more volatile than the overall index. For example, a beta of 3.0 suggests that the stock will move thrice as much as the market.
- A stock with a beta of exactly one (1) suggests that the stock is theoretically exactly as volatile as the overall market.
Beta is calculated using historical average movements of a stock and does not take new information into consideration. Therefore, the performance of a stock may not necessarily match the theoretical implications of its beta.
Example:
The Case of Considering Beta before Buying the Shares of ‘Company A’
‘Company A’ (Oil & Gas Industry) has a Beta of 1.5. It is suggested that when the market makes a return of 10%, ‘Company A’ will make a return of 15%. But due to a spike in oil prices, ‘Company A’ could make a return of 35% – which is more than twice the gain implied by its beta.
However, it is a fair metric to consider when trading in short time periods.
Note, however, that a high beta does not necessarily mean that the stock is risky, and a low beta does not necessarily mean a stock is safe.
Consider the Bigger Picture Before Investing!
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