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The higher the risk, the higher the returns. This is a common adage attached to the stock market. Every investor who enters the stock market hopes to earn the highest amount of profits with the invested amount. However, stocks that offer high potential profits come with a high risk of losing capital or depreciating value. In such cases, investors are left with no choice but to analyze their risk appetite and invest in stocks that limit risk exposure.
However, for investors to choose stocks that match their risk appetite is tricky. For example, a high-risk investor who has diversified within asset classes may want to invest in high-risk stocks as they can offer higher returns. On the other hand, an investor who is just starting in the market may want to invest in less risky stocks even though they may offer lower profits.
BETA in the share market is an indicator used by investors to assess the risk attached to a specific stock. It is a great way for investors to measure a stock’s volatility and ensure that they adjust their positions or buy/sell the stock. BETA in the stock market works by assessing the risk of stock concerning the overall stock market. For example, BETA in the stock market defines the risk of a stock concerning stock market indices such as NIFTY, SENSEX, etc. If the indices are rising, but the price of the stock is falling, an investor can assess this risk through the BETA values.
The method of BETA assigns a value of 1 to the stock market or any comparable indices such as NIFTY or SENSEX. Afterward, individual stocks are ranked above or below 1 based on how much they deviate from the overall market’s performance or the indices. If the rank given to a particular stock is above 1, it means that the stock is moving more than the market and is called a High BETA stock. However, if the ranking is below 1, it means that the stock is moving slower than the overall market and is called a low BETA stock.
For example, suppose invest in the stocks of ABC Company. You want to assess the risk attached to the stock and whether it is a high BETA stock or a low BETA stock. It is calculated as below:
Beta (β) = Co-variance of a specific stock with a benchmark index of the share market/The variance of the respective security over a specific period.
Now, you need to find the BETA value compared with NIFTY. Based on the recent five-year data, the correlation between ABC and NIFTY is 0.50, the standard deviation of returns of ABC is 25.50%, and NIFTY is 30.50%. In this case, the BETA value will be:
BETA of ABC = 0.50x (0.2550/0.3050) = 0.4180
As the value is lower than 1, the shares of ABC would be considered less volatile than NIFTY.
There are four types of BETA values, allowing investors to understand the risk attached to the stocks. These are:
β>1: BETA value greater than one with a stock implies they are performing better than the overall market. These stocks are called high BETA stocks and can allow investors to earn substantial profits. However, such high BETA stocks accompany a high-risk factor with a possibility that the price can crash anytime to average with the present market.
β<1: BETA value lower than 1 with a stock implies they are performing lower or close to the overall market. These stocks are called low BETA stocks and can allow investors to earn lower but steady returns. Such stocks come with a low-risk factor and are considered stable against the volatility of the market.
β=1: BETA value equal to 1 signifies that the stock is ideally co-related to the stock market or the indices. These stocks are also considered stable and have a parallel effect on the share price and the returns with market fluctuations as the comparable indices. Generally, stocks of large-cap companies have a BETA value equal to 1 as these companies are the major part of such indices.
β<0: Securities other than stocks have a BETA value of 0 when compared to stock market indices. For example, gold is a security that may have a BETA value of 0, signifying that its value may rise over time, irrespective of how the stock market indices are performing. Investors use these securities to hedge against a stock market crash.
There is a well-known argument regarding BETA as it does not differentiate between a stock’s upside or downside price movement. It may be that the market is falling continuously, and yet a stock may have a BETA value lower than 1, as it may also be declining continuously. For investors, falling prices are a risk, while climbing prices are an opportunity for making profit. However, BETA doesn’t clarify this difference. Therefore, investors need more intuitive tools to make informed decisions, which can be found on a reliable trade terminal or stock trading app.
Value investors do not believe in BETA as it promotes that a stock that has fallen sharply in price (β<1) would not give better profits than stocks that have climbed in price (β>1). On the contrary, value investors think that such stocks provide better profit-making opportunities over time.
Understanding the BETA stock market definition can help you know how high the risk can be when investing in stocks and allow you to make informed decisions. The market has a BETA of 1.0, and the BETA ratio in stock indicates how it might move.
A good BETA value depends entirely on your risk appetite. If it is higher, you can choose a stock with a BETA greater than 1. If your risk appetite is low, you can go for a stock that has a BETA value of less than 1.
BETA can allow investors to access the risk attached to a stock. It is also a vital factor for investors who undertake the Capital Asset Price Model (CAPM) to understand a stock’s return potential.
High BETA stocks can allow investors to earn hefty profits. However, as they come with a high-risk factor, they can be bad if your risk appetite is lower.
BETA can take values lower, higher, equal and negative (0) values than 1.
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