What is Beta?

Beta is a measurement of the risk or systematic risk of a portfolio or security.of an investment or portfolio in comparison to the market in general. Beta is utilized in the model of capital asset price (CAPM) which explains the relationship between risk posed by systematics and the expected returns for investments (usually stock). CAPM is widely utilized as a method of pricing risky securities and to generate forecasts for the anticipated returns for assets, taking into consideration the risk involved in these assets and the price of capital.

Key Takeaways

  • Beta, which is used primarily within the Capital Asset Pricing Model (CAPM) is a gauge of the risk of an investment or portfolio when in comparison to the market in general.
  • Beta data on a particular stock will only give investors an estimate of how much risk it will bring to the (presumably) diversified portfolio.
  • To be considered meaningful, beta for it to be meaningful, the stock must be linked to the benchmark being used to calculate the beta.

Beta Interpretation

The b of a security should only be used if its high R-squared value is greater over the benchmark. The R-squared value is the amount of variation in the price of shares of a security, which can be explained by changes within the index that it is benchmarked against. For instance, a gold ETF will have the lowest b and R-squared relative to a benchmark equity index because gold is negatively associated with equity.

A b of one indicates that the value of a security is in line in line with market trends. A b that is less than 1 means that the securities are not as volatile as the market overall. In the same way, a b greater than 1 means an increase in volatility than markets overall. Certain industries are more likely to be more volatile than those in other industries.

For instance the b for most tech companies is usually greater than 1. Additionally, a business that has a b of 1.30 can theoretically become 30 percent more volatile than market. In the same way, a business with the b value of 0.79 is theoretically less volatile by 21% that the marketplace.

If a company has an b that is negative this means it is towards the opposing direction to the market. This is theoretically possible however, it’s very rare to come across an investment with a negative b.

Levered Beta vs. Unlevered Beta

The Levered Beta (equity beta) is a number that measures the risk of returns for an individual company’s stock to the market’s overall returns. This, in essence, is a gauge of risk and also includes the effect of a company’s design and the leverage it uses. Equity beta lets investors determine how vulnerable the security is to the macro-market risk. For instance, a firm that has a b value of 1.5 indicates returns that are 15% as unstable as the market it’s being measured against.

When you check the beta of a company on Bloomberg the default number that you see is a levered number, and is a reflection of the company’s debt. Because every company’s capital structure differs analysts will typically be looking at the degree to which “risky” the assets of the company are, regardless of the proportion of equity or debt financing.

The higher the company’s leverage or debt is, the greater percentage of its profits will be used to pay for the debt. When a company takes on to its debt load, the uncertainty surrounding future earnings increases. This increases the risk that comes with the stock of the company, however it’s not due to risk of the market or industry. Thus, by eliminating the debt-related leverage (debt impact) as well as the unlevered beta will be able to assess the risk associated with the assets of the company.

Beta Values in Types

Beta Value equal to 1.0

If a company has beta greater than 1.0 means that its price is highly correlated to the market. A stock that has beta greater than 1.0 is a stock with a systematic risk. But the beta calculation cannot identify any risk that isn’t systemic. The addition of a stock to the portfolio that has the beta value of 1.0 does not add risks to your portfolio, however it won’t affect chances of the investment portfolio to yield an extra return.

Beta Value Less Than One

A beta value of lower than 1.0 indicates it is lower risk than the stock market. Incorporating this stock into an investment portfolio is more secure than a portfolio that does not include the stock. For instance, utility stocks usually have low betas due to the fact that they generally be more slow as compared to the market’s averages.

Beta Value Higher than One

A beta higher than 1.0 signifies that the stock’s price could be higher than that of the marketplace. For instance, if a security’s beta is 1.2 It is believed to be 20 percent more volatile than market. Small-cap and technology stocks typically have more beta over the benchmark market. This suggests that adding the stock to a portfolio can increase the risk of the portfolio however, it could also boost the expected return.

Positive Beta Value

Certain stocks have betas that are negative. The beta value of -1.0 indicates it is not linked to the market benchmark. The stock can be viewed as an opposite mirror image of the trends of the benchmark. The inverse and put options were designed with negative betas. There are also industries, such as gold miners, in which the negative beta is prevalent.

Beta in Theory in Theory. Beta in the Real World

The theory of the beta coefficient assumes that the returns of stocks are typically in a statistical manner. But, financial markets are susceptible to massive unexpected events. In fact, returns aren’t generally evenly distributed. So the beta of a stock could indicate about a stock’s future performance isn’t always the case.

A stock with a low beta might have fewer price swings but it might be in a downward trend for the long term. Thus, adding a downward-trending stock that has a low beta reduces the risk of a portfolio when the investor views the term “risk” by its the volatility (rather than the potential loss). From a practical point of view the low beta of a stock that is in the downswing isn’t likely enhance the performance of a portfolio.

In the same way, a beta-high stock that fluctuates with a tendency to go up can increase the risk associated with an investment portfolio, however it can also add value also. It is suggested that investors using beta to analyze the value of a stock, also look at it from other angles–such as technical or fundamental aspects–before making the assumption that it will increase or reduce risk in the portfolio.

Beta’s disadvantages

Although beta may provide valuable information in assessing an investment but it also has its limitations. Beta can be useful for assessing the security’s risk in the short-term as well as for analyzing fluctuations to determine cost of equity when employing the CAPM. But since beta is calculated using old data, it is less useful for investors trying to predict the future direction of a company’s fluctuations.

Beta is not as effective in long-term investment because the volatility of a stock can vary drastically from year to season according to the company’s growth rate and other aspects.

What is Equity Beta and Asset Beta?

The Levered Beta, commonly referred to as equity beta, or stock beta, refers to the risk of returns that can be attributed to stocks which takes into account the effect from the firm’s leverage based on the structure of its capital. It examines the risk (risk) in a leveraged company with the risk associated with the market.

Levered beta encompasses both risks to business and the risk associated with borrowing. It is also known as “equity beta” because it is the risk of equity based the structure and structure it is based on.

Asset beta, also known as unlevered beta, on contrary, is a measure of the risk associated with an unlevered business relative to market risk. It also includes risk to business, but not the risk of leverage.