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The stock market is well-known for its risks. The prices of stocks fluctuate so often that investors may lose all their profits in a moment. But do you think analysing the risk associated with these stocks will help? Well, it may not help eliminate the risk, but it at least warns risk-averse investors to stay away from high-risk stocks.
One such tool that is widely used in the stock market is beta. In today’s article, let’s understand what beta is and how investors use this to analyse risks.
What is beta in the stock market?
Beta is a measure used in the stock market that helps assess the risk associated with a stock. It is a relative measure that compares the risk of an individual stock against the entire market to determine whether the stock is high-risk or low-risk.
How does beta work?
Beta is a statistical measure that tries to establish a relationship between a stock’s risk and the market’s risk. It is done by comparing the returns on an individual stock against that of a benchmark index.
While there are risks of different kinds, beta focuses mainly on systematic risk that affects the entire market. It primarily indicates the risk of a stock based on its volatility due to market events. To do so, it analyses how a stock’s price moves when the benchmark index fluctuates.
For example, consider the index NIFTYPHARMA. Aurobindo Pharma is an individual stock that is part of the index. So, when the value of NIFTYPHARMA fluctuates, the value of Aurobindo Pharma fluctuates, too. The degree of fluctuation of the index and the stock are compared to assess whether the stock is more volatile than the market or less volatile.
High-beta and low-beta stocks
The beta of the market is generally set at one. So, a stock’s beta whose value is greater than one is said to be a high-beta stock. A stock with a beta value of less than one is said to be a low-beta stock.
Beta > 1: High-beta stock
Beta < 1: Low-beta stock
A high-beta stock carries more risk as compared to its peers in the market. Such stocks are more volatile, and their prices are prone to higher fluctuations. Hence, the profits and losses associated with such stocks are also higher than the market.
A low-beta stock, on the other hand, works conversely. These are low-risk stocks whose prices are stable as compared to the market. Such stocks offer both profits and losses in moderation.
Generally, small and medium-cap stocks are high-beta. It is because such stocks are on the verge of growing, and they usually react more to market events. Large-cap stocks are low-beta since they are already settled well in the market. The growth of such stocks has already reached a peak, due to which market events do not disturb them to a large extent.
Example of a high-beta stock
Consider the example of Bajaj Finance Ltd. The stock is trading at ₹6,909.95 as of 18 April 2024. Over the past 6 months, the stock price has constantly been fluctuating, showing a dip of 12.12%.
Bajaj Finance Ltd’s 6-month beta as of 15 April 2024 was reported at 1.49. The beta value shows that it is 40% more than the industry average, suggesting increased volatility in share prices, making Bajaj’s shares a risky investment option today.
Benefits of high-beta value stocks
- High-beta stocks offer higher-than-normal returns to investors when the market is going upward.
- They are a great option for diversifying investment portfolios. Having a few high-beta stocks can help offset the loss from other instruments, especially when the market reverses after a downtrend.
- High-beta stocks fluctuate rapidly. Hence, such stocks help intraday traders book profits during the day.
Limitations of stocks with a high-beta value
- With the possibility of high returns, high-beta stocks also bring the risk of high losses. When prices move in the reverse direction, the losses are significant.
- Since these stocks are prone to extreme fluctuations, they trigger impulsive decisions in investors.
- High-beta stocks are highly volatile, and predicting their movement is quite complex. This makes decision-making harder for investors.
- High-beta stocks may also face liquidity risk since the market may not have many investors open to high levels of risk.
Bottomline
Beta is a numerical value that suggests how volatile a stock is. Calculating beta and applying it in investment strategies can help choose stocks that fit well in their financial objectives.
A beta of more than one suggests high risk and is suitable for investors with high-risk tolerance. Such stocks also offer higher returns in a booming market. A beta of less than one indicates low risk and is ideal for risk-averse investors who expect reasonable returns.
So, the next you want to choose a stock to invest in, do not forget to check its beta level. Happy investing!
FAQs
The formula to calculate beta is:
β = covariance/ variance
Where covariance is calculated between stock returns and index returns
Various financial websites publish beta values. Investors can use such websites provided the numbers are accurate and consistent across all websites.
Some stocks on NSE with a high beta value are:
Bajaj Finance with a beta of 1.69
Adani Enterprises with a beta of 2
Tata Motors with a beta of 1.72
Adani Power with a beta of 2.83
DLF with a beta of 1.85
Whether a high beta is good or bad depends on each investor. If you are an investor who wants to exploit the extreme fluctuations in stock prices, a high-beta may seem like a good opportunity to make profits.
You should buy stocks with a low beta if you are a risk-averse investor. Stocks with a low beta score are less volatile and fluctuate less than other stocks in the market. Hence, they have low exposure to risks, but their returns are also moderate. So, if you are an investor looking to preserve your capital with reasonable profits, low-beta stocks may be the right choice for you.
A beta score of 1.5 is high. It suggests that the stock falls under the high-beta category and is exposed to high risk. A beta score of 1.5, as compared to a beta of 1 in the market,
suggests that the stock fluctuates 50% more and hence is more risky.