Beta stocks are referred to highly volatile securities, having a high degree of responsiveness to all market fluctuations. All share market instruments have a corresponding stock beta, evaluated against the potential risk and return parameters as per market performance and underlying strength of an issuing company.
How is Beta in the Stock Market Determined?
Beta is the coefficient of variation of a stock demonstrating the rate at which the value of security changes in response to market movements. The formula of beta is calculated as follows –
Beta (β) = co variance of a specific stock with a benchmark index in the share market of India / The variance of the respective security over a stipulated period
Theoretically, the beta value of a benchmark index is considered to be 1. The risk factor of securities is evaluated around this number, wherein a stock having a beta coefficient higher than 1 is deemed to be a risky investment venture. Such a value indicates that the corresponding share is likely to demonstrate high fluctuations corresponding to sway in the stock market.
During periods of a boom when the stock market is soaring, the high beta value of stocks is expected to generate manifold returns. On the other hand, a downswing of the share market can lead to substantial losses, as a fall in the value of benchmark indices can have an adverse effect on beta stocks.
Types of Beta of Indian Stocks
Beta value differs among securities, as well as respective benchmark index against which it is calculated. It can primarily be of four types –
Beta value of greater than 1 implies a high degree of responsiveness of the corresponding stock with the share market. Such shares are expected to deliver substantial returns on total investment, and usually comprise securities issued by small and mid-cap companies.
Nonetheless, a high risk factor is also associated with such shares, as underlying companies often lack the financial backing to cover all the costs in case of market adversity. As a result, any dip in benchmark index points leads to a severe fall in the value of corresponding stocks.
Such coefficient reflects the relative stability of a stock. The beta of Indian stocks less than 1 label an investment venture as relatively stable, as the fluctuation of returns generated are not massively affected by variations in the stock market.
- β= 1
These securities have a parallel effect on a share price and its ROE with market fluctuations in a similar manner when compared to a benchmark index. Large-cap companies have a beta value of 1, as it is the primary constituent of major benchmark indices operating in the country.
Investment tools having no associated risks demonstrate a beta value of 0. Government bonds, fixed deposits, cash, etc. fall under this category, and is ideal for individuals looking for investment avenues for the security of corpus.
Securities having an inverse relation with stock market seem to hold negative beta coefficients. In the event of drastic stock market fluctuation or crash, investors often pool their money in these securities for higher returns. Gold is a significant example of such investment tool having a negative beta, as its value tends to rise over time. It not only poses a secure tool for investment but also acts as a hedge against inflation.
Who Should Invest in Beta Stocks?
The beta of Indian stocks helps investors gauge the risk factor associated with respective securities. Individuals having a high aptitude for risk can invest in stocks having a beta value of higher than 1, to ensure substantial returns on the portfolio. Nonetheless, such investors have to be prepared to bear extensive losses in case of unforeseen circumstances resulting in a downswing of the stock market.
Usually, small-cap and mid-cap companies have a beta value of higher than 1 on their respective stocks, as their potential for growth is extensive. Purchasing stocks or bonds of such businesses can lead to substantial wealth accumulation through significant annual returns. Individuals can enjoy such returns through dividend pay-outs or capital gains through a resale at a later date.
Risk-averse investors, on the other hand, can opt for stock beta less than 1, for a relatively stable investment venture. Fixed return instruments are usually associated with such beta value, as returns of respective instruments are not directly affected by stock market fluctuations.
Beta value of stocks can also be 1, indicating a similar fluctuation rate among indices and corresponding securities. Large-cap companies often have a beta value equivalent to 1, as they are the primary components of major indices present in a country. While investment in such securities might not lead to ample capital gains, high-value dividend pay-outs often lead to wealth generation of investors. Investment in such companies is preferable as they have the requisite financial base to tackle the downswing of the business cycle, which, in turn, ensures no drastic fluctuation in the stock price.
Advantages of Beta Stocks
- Reflects associated unsystematic risk
Beta value of securities is one of the significant coefficients investors analyse before investing. It helps individuals analyse the unsystematic or market-related risk related to a company, thereby indicating the level of interdependence between the two parameters.
While risk-averse individuals look for securities having a relatively low beta value, people looking to extract substantial capital gains from this sector often tend to invest in stocks of small and mid-cap companies, demonstrating a high potential for growth.
Alternatively, investors looking for stable securities to generate steady cash flow through dividend payments can invest in stocks having a beta value of 1. Though appealing, such shares are relatively expensive to procure.
- Demonstrates past performance
Stock beta also reflects the past performance of a stock with respect to the performance of the stock market through a stipulated benchmark index. This helps potential investors analyse the expected return on equity on the total amount pooled into such securities.
Limitations of Beta Value of Stocks
Beta value of securities provides no indication of the systematic risk associated with such investment tools. In other words, the underlying performance of issuing companies cannot be comprehended through such coefficient figures. As a result, individuals run the risk of investing in value trap securities if they choose to pool their money based on the only beta in the share market.
Beta value of stocks, hence, is a vital tool investors should look into before investing in any stock market instrument. Though not an all-inclusive value, beta helps investors analyse the market risk associated with a stipulated instrument, and its effect on respective returns generated.