Beta measures a security or portfolio's volatility, or systematic risk, in relation to the market as a whole (usually the S&P 500). Generally speaking, stocks with betas greater than 1 are thought to be more volatile than the S&P 500. If beta is smaller than 1 the stock(s) is less volatile. And if beta is equal to 1, then volatility is neutral. The capital asset pricing model (CAPM), which analyzes the connection between systematic risk and projected asset returns, employs beta (usually stocks). The CAPM approach is frequently used to value hazardous securities and to predict projected returns of assets while taking into account both the risk of those assets and the cost of capital.
Understanding Beta
A stock's volatility and risk can be quantified using beta. A greater beta indicates that the stock is more vulnerable to market fluctuations. A stock with a beta of 1.5 would hypothetically experience a 15% decline if the market as a whole dropped 10%.
A stock's cost of equity can be calculated with the help of a model called the Capital Asset Pricing Model (CAPM), and beta is a key component of this model.
Analysts utilize the Capital Asset Pricing Model (CAPM) to calculate the cost of equity for a stock and hence whether or not the stock is economically profitable.
The biggest problem with beta is that it only looks at the past. In the short term, many volatile stocks tend to remain volatile, but this is not always the case.
Let's say, for the sake of argument, that a company regularly skirted the edge of bankruptcy due to inept management. It's under new management now, and it's paying down debt and paying dividends. Although the company has reduced its risk profile, its stock may maintain the same beta.
Investors can find a potential for profit in these stocks, since their price could be undervalued if the market is incorrectly using beta to determine its worth.
Pros
- The Capital Asset Pricing Model (CAPM), where beta plays a role, is a helpful tool for determining a stock's current cost of capital. The cost of capital is a key variable in determining economic profitability and in establishing discount rates.
- Alpha is complicated, but beta is simple. A value greater than one indicates that the stock is more volatile than the index, while a value of less than one indicates that it is less volatile. You may get a feel for the market's opinion of a stock right away, which is helpful for planning the rest of your research. Any stock with a significant beta is likely to grow at a rapid rate.
- Instrumental in Portfolio Evaluation. The beta of a portfolio can be calculated in addition to the betas of individual equities. Use the above calculation with your portfolio's past price history, or calculate the weighted average beta of your positions.
- Even though market timing is never a good idea, if your portfolio's beta is much higher than one, it could be time to add some stocks that offer greater diversification, such as low-volatility value stocks. Your investment portfolio may suffer more than required in the event of a market downturn.
Cons
- Although beta indicates a stock's historical volatility in comparison to the index, it does not predict future volatility. You should view the beta measurement with some caution and take into account both past performance and the present context.
- Systematic risk is the only type of risk that is measured. The sole kind of risk that beta measures is the stock's exposure to a decline in the market as a whole. It's also possible to face unexpected challenges, such as an excessive amount of debt, the loss of a major litigation, or a decline in consumer demand. Even though the market is rising, the stock price could go down due to the aforementioned dangers.
- Volatile measure. A high-flying growth stock's beta will likely be higher six weeks after the company delivers gangbuster earnings than if it were measured during a dead period.
Bottom Line
The concept of beta is helpful for quantitative investors. However, the more qualitative your investigation is, the less use beta will be.
Furthermore, beta becomes less effective the longer your investing horizon is (which is ideally as long as it may be). A company's volatility during the last year is irrelevant if you want to invest in it with the expectation that it will yield positive returns 10 years from now.