Using Beta to gauge volatility.

If your heart has a high beta level, invest in a stock that has low beta!

Hi there ,

Beta is a measure of a stock’s price volatility in relation to the rest of the market. In other words beta is a measure of risk. The ‘rest of the market’ would be represented by any broad index that represents the market. Hence, in India, the broad based index could be the Sensex or the nifty.

Understanding beta is simple.

  • Stocks that have a beta greater than 1 have greater price volatility than the overall market and are more risky.
  • Stocks with a beta of 1 fluctuate in price at the same rate as the market.
  • Stocks with a beta of less than 1 have less price volatility than the market and are less risky.So, if the market goes up 20%,a stock with beta 1 goes up 20%. If the Market is down 10%, the stock comes down 10%. This is, of course, calculated over a period of months and does not necessarily hold true on a daily basis.

NOT ONLY FOR INDIVIDUAL STOCKS..

Not only for individual stocks, beta measure can also be computed for the entire industry.  That would compare the volatility that industry relative to the market.

If you know the industry beta, it would be possible for you compare a stock relative to the industry and the market.

For example, if you know that the beta for information technology stocks was 1.5 and you found a company in that industry with a beta of 0.7, this would tell you that the company is not only less volatile than the market as a whole, but extremely stable compared to its industry.

Beta can be constructed for your individual portfolio also. Beta of a portfolio should be the weighted average betas of securities comprising the portfolio.

Beta measures of a stock is useful in finding the cost of equity using the CAPM method. I ‘ll explain more on that when we discuss about cost of equity in our valuation section.

WHERE TO FIND ?

All financial information web-sites like moneycontrol have information about a stock’s beta.

PROBLEMS WITH BETA.

While the ‘beta’ may seem to be a good measure of risk, there are some problems with relying on beta scores alone for determining the risk of an investment.

Beta is computed with historical data.

Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a bull market, the stock that outperforms all will have  beta that’s greater than 1.

HOW TO USE BETA.

Beta is useful for short term decision making. In short term decisions, price volatility is important. Since beta measures exactly that, it useful for that class of investors.

In a rising market, it’s good to have high beta stocks and in a falling market it’s better to stick to low beta shares.

Later when I talk about risk premium, we will find more applications of beta. For the time being, remember beta as a simple and very valuable tool to gauge volatility.

Bye for now ..

Have a nice day !!

You may like these posts:

  1. Price to Earnings ratio or P/E ratio
  2. Understanding Bollinger Bands.

2 Responses to “Using Beta to gauge volatility.”

Akshay

November 17, 2012 at 4:07 pm

Hello Jins,
I could not find the beta value on Money control.
Could you pl. help??

J Victor

November 17, 2012 at 11:01 pm

http://www.nseindia.com/archives/archives.htm
check the link above. on the window you get, click on iisl monthly reort and type the date to get beta of nifty stocks.

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