No matter what individuals are doing they like to be in control of the situation, they like to know what is the risk associated with it, and also is it worth taking the risk for the benefits that come with it. Any rational person will not make any investments/choices irrationally, one of the most important things investors consider while deploying money in any security is checking the ‘Beta’ of that particular stock. So what exactly is Beta, and is it really that important?
The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. Beta is a measure of risk and it allow people to be in control or at least makes them believe so.
Breaking Down Beta
The volatility of the stock by x percent when the market moves by 1% is the beta of the stock. A stock with a high beta will have higher volatility and vis-à-vis a stock with lower beta will have a lower volatility. Beta is a good measurement of systemic risk in the market. Systemic risk is the risk that can be not controlled by the company issuing the security. The General measure for Beta is 1.
Beta as I mentioned shows the returns that the security will give when compared to the market. So running a regression on co-variance of daily returns of the security with respect to the markets divided by variance of daily market returns. You can easily do it by shooting up your computer, going to Yahoo/ Google Finance and finding the daily price table of the stock and the market and then putting it in an excel and using the formulas of covariance and variance.
Applications of BETA
- Beta is used in calculating the expected returns of the stock or portfolio in Capital Asset Pricing Model (CAPM).
- Beta of listed companies of the same industry will help you find the beta of an non listed company while doing valuations.
- Beta of an industry will help you identify potential industries to invest in on happening of certain events
- In case of sensitive securities with higher risks like options, the beta is a very important measure to assess the risk and returns associated with it.
With all the good things that come with Beta, it cannot go without getting some criticism. In many cases it is seen that the security does not behave as it is supposed to behave in normal market conditions, hence making the use of beta more reliable or rather useless. Beta only captures the systemic risk of the company, the risk within the country cannot be measured using Beta. Also when the beta is calculated it is the raw beta for the company.
Raw Beta can be known as the historic beta of the company. This beta cannot be in line with the market beta because the company may be comparatively new and may not be diversified enough to absorb the shocks in the market. While calculating the beta on a Bloomberg terminal, the terminal also showcases an adjusted beta. This beta is the estimate of security’s beta in the future.
Adjusted Beta = 0.67* Raw Beta + 0.33* 1
It is believed that in long run the beta for any company will be near to 1, because the company may diversify and absorb more shocks from the market. Therefore after assigning 1/3 of weight to 1 and 2/3 of weight to the raw beta we arrive at the adjusted beta. This method is given by Bloomberg, however there is no justification given by them in regards of weight allocation to adjusted and raw beta.
There is one more complication whilst calculating the beta. Beta can be calculated using monthly, weekly, daily or quarterly returns and also can be regressed against the index of our choice. There is no uniformity being followed as to which set of pair is to be followed as there are several permutations and combinations available. Bloomberg reports a standard beta for 2 year weekly data and for a US company it is regressed against the S&P 500 index, this is because S&P 500 is a broad index.
However, the logic is forgotten when reporting beta for an Indian company. Indian stock is regressed against BSE SENSEX, which is the index for securities with top 30 market capitalization in the country. This is done just because SENSEX has more correlation to the S&P 500. The best way to calculate the beta is to calculate it yourself with the combination of time frame and index which will be right for your calculations.