Stock Beta
Stock Beta is one of the most used and misused of the financial ratios. The beta is a measure of a stock’s price volatility in relation to the rest of the market. In other words, how does the stock’s price move relative to the overall market. The basic premise is that a rising market generally tends to boost most stock values with it, while a falling market is apt to lower them.
Importance of Stock Beta Value>
By Dan Pipitone
Beta value of a stock is the measurement of the volatility of a stock in comparison to the volatility of the market. It is a simple and very useful indicator that all traders and investors should be aware of. Calculation of beta value of stocks is essential with many trading/investing strategies especially with Capital Asset Pricing Model (CAPM), which describes how much risk that one can take to get a desirable return or vice versa.
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Many financial sites, broker sites and trading platforms offer real-time and daily beta value of stocks. When calculating the beta value, the volatility of the market is taken as 1 and the beta of stock is calculated as how much the stock price moved in comparison to this market volatility. The value can take one of the following forms.
Negative beta: This is an interesting but rare condition where the price of the stock moves in reverse direction to the market movement. Usually no stock has prolonged negative beta value as most (all) them move with the market.
Zero beta: This is another rarity, where the price of stock stays same over time irrespective of market movement. This can sometimes happen in sideways moving markets, where no major economic/industry/company news is coming up.
Beta less than one: This happens when the stock price moves less in comparison of market. Many blue-chip and large-cap company stocks have beta value less than one, which make them qualify for low-risk investments. But these stocks tend to offer low-returns; and are not so suitable for short-term trading.
Beta of one: This happens when the stock price movement is same as that of market. This is true for many index-linked stocks and funds.
Beta greater than one: Beta exceeds one when the stock price movement surpass market movement. Many fast growing, mid and small-cap company stocks have beta higher than one. These stocks tend to offer better return for high-risk taken, but many of them are less suitable for long-term investing. Remember, very high beta levels may indicate low liquidity causing increase in volatility.
Knowledge of beta value is essential from a trader’s perspective as many experts believe that about 70 percent of stock price movements are with respect to market changes. In general it is believed that investing in instruments with high beta is good in rising markets and investing in low beta instruments is good in falling markets.
Advantages of beta value includes: simplicity in calculation, easy to apply and helpful in finding right trading instruments. Disadvantages of beta value includes: as it is based on historical data there is no guarantee of future returns, not applicable for newly issued stocks, does not distinguish bearish and bullish trends and it do not consider the value of the instrument.
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