Stock Beta: What is High and Low Beta Stocks
Stock beta – is a measurement of volatility – the quality that represents the likelihood of market risk in terms of some specific asset. However, it’s only a simple explanation. Understanding exactly how beta works is a far more challenging task.
First of all, beta is tightly associated with another factor called systematic risk. It’s a type of market risk that highlights changes on the market as a whole. Simply speaking, if you take the volatility of your chosen asset and compare it to the systematic risk variable, you’ll get your beta number.
The key takeaway is this: beta is a risk measurement, and it shows you if your asset if different from the current market in terms of market risks.
How is it calculated?
There’s actually a set formula for such calculations. This formula takes into account several types of value correlation measurements (the relationships between two indicators). You’ll need to such relationship indicators:
- Variance – it shows basically how different the stock returns of the current market re in comparison to the overall returns on the wider market. The ‘distance’ between them is called variance.
- Covariance – it shows you the difference between the returns of your stock and the changes on the current market.
So, in order to calculate the beta coefficient (the volatility) of your specific asset, you’ll have to compare it to the average of the market you’re currently on. Then, you’ll have to likewise compare it through a division.
As a result, you get this formula:
The ‘destination’ of the beta coefficient is an important factor in understanding if your asset correlates with the general mood of the market, while keeping one eye on the volatility of your own market. This way, you can both check on the systematic risk and the unsystematic risk that your asset brings into portfolio.
While systematic risk is all too familiar to you, unsystematic risk is the new concept in this article. Unsystematic risk is different in that it highlights the volatility linked to the current market’s own policy, it’s a small-scale factor, but nevertheless very influential.
Beta coefficient is usually used by the professional investors in their CAPM (capital asset pricing model) calculations. This model helps them understand the relative risk of their new asset in regards of the platform, exchange, etc.
You can deduce beta for each of your assets without any problem. You’ll probably need the software to calculatуe both varience and covariance, however. Fortunately, there are many beta calculators online, so it only a matter of reading the results.
How to read beta?
Beta coefficient can take several forms, here’s how you read them.
- β= 1.0
If the beta coefficient is equal to 1.0, then its relationship with market movements perfectly coincides. The closer number gets to 1.0, the more similar risks will become. The coefficient of 1.0 itself implies identical volatility.
If you add the asset of such volatility to your portfolio, it means you may experience systematic risk, but there will be no unsystematic risks involved.
- β< 1.0
If your beta coefficient is less than 1.0, then the stock must be less volatile in comparison to the average market movements. By adding such stock into your portfolio, you’ll decrease its average volatility, and, consequently, risk fewer losses.
- β> 1.0
High beta stocks (more than 1.0) are technically more volatile than the market on average. Adding such asset to your portfolio will increase the average volatility, and thus decrease the possibility of profits.
- β< 0
It can also happen that your beta coefficient proves negative. It’s not a flaw in system, it happens. If the results of the calculations are inverted, than the relation of your stock to the market movement must also be inverted, opposite. So, if the market’s current trend is call options, then the negative beta suggests your stock is currently on put.
The disadvantages of beta
Beta is very limited in its capabilities in terms of long-term planning. It doesn’t take into account the bigger picture and the long-term growth or fall. The job of CAPM is to determine the current, short-term volatility, usually for swing trading and the similar investment strategies.
However, if what you want is to determine the volatility rate for long-term investments, beta measurement won’t help you. For one, beta doesn’t seem to register the ongoing trends, increasing or decreasing. The asset may have an extremely low volatility, but at the same time follow a downward trend.
And on the contrary, stocks with high beta may be a profitable addition if the current trend is looking upward. For two, very long-term investments (up to several years) can’t be processed by beta. It only takes into consideration the changes the events that already happened, not the possible future developments, and only in short-term.