Beta in Indian Stock Market: Guide for Newcomers

The Meaning of Beta in the Stock Market

Introduction

The Indian stock market has come a long way in the past four decades. The decadal growth has been astronomical. Today different financial assets exchange hands daily worth crores of rupees. Investors and traders today are very much aware of the risk associated with the stock market because of the considerable money involved. In addition, every financial asset or stock has its inherent risk. We can quantify such risk through Beta in the stock market. Beta meaning in the stock market is the risk associated with individual stock compared to market risk.

A stock does not always move synchronously with the index. We find many stocks are moving every day with the indices but the amount of movements are different for each. Sometimes a stock may move more than 10% of its value in a single day but we do not see the same amount of movement in indices. This happens due to beta. An investor or a trader will be aware of the amount of movement of a stock if the beta is known. This helps in risk management. A big fall will not unnerve the investor if the trader is aware of beta.

This article will give a complete overview of Beta and can help newcomers in the Indian stock market to understand the concept of Beta. Therefore, market participants can use this as a reference guide as this article covers all the basic aspects including calculations.

What is Beta in the Stock market?

What is the Beta Value
Beta in the Stock Market (image courtesy www.investopedia.com)

The stock market is always exposed to systematic and unsystematic risks. Such risks affect the market as a whole and affect each stock as well. Beta is the systematic risk of a stock compared to the market systematic risk. In other words, beta is a stock’s volatility compared to the volatility of the index.

Systematic and Unsystematic Risk to Understand the Beta Meaning in the Stock Market

Systematic risk and unsystematic risk are the two types of risks that affect the market as a whole and affect the performance of a stock. A trader needs to be aware of these risks to understand what beta meaning is in the stock market.

Systematic Risk and Beta

Systematic risk is the risk that is associated with different macro-level risks such as risks from socio-political changes, political changes and economic changes. Such risks affect the market as a whole and affect the volatility of each stock too. Beta arises from systematic risks.

Unsystematic Risk and Beta

Unsystematic risk arises from different factors that are unique to an industry or a firm. The firm’s management capability, consumer preferences that affect its products or services, labour issues etc. causes unsystematic risk. Such risks are somewhat controllable by the diversification of the portfolio of investors. Unsystematic risks do not contribute to beta but affect the ROI of the stock.

Calculating Beta in Stock Market

Calculation of Beta in the Stock Market
Calculation of Beta in the Stock Market

Beta values are calculated using one or more independent and dependent variables. In the formula of beta, as shown above, Y is the returns from the stock which is a dependent variable and X is an independent variable denoting market returns.

Var is the variance which is the square of the Standard Deviation (std-dev). Covariance (COV) is a statistical measurement that denotes how two variables co-vary. The following is the formula of covariance.

Formula for Covariance
Formula for Covariance

In this formula for covariance, N is the number of observations and bar X and bar Y represents the arithmetic averages of X, Y. t – denotes the time span of which the values are taken.

When we calculate the beta value of a stock, we multiply the beta value of the stock in a portfolio by its weightage to get the weighted average beta value of a stock in a portfolio.

Interpreting Beta Values

Interpretation of beta value is important for an investor. Beta values represent the volatility expected from a stock with respect to the market volatility within a specific period. During highly volatile conditions, the investor will be aware of the range of fluctuations of a particular stock. Such information helps an investor take the right decisions on investment.

Different stocks have different beta values. We are going to discuss below the true implications of the beta values of different stocks. Beta values can be of three types. Beta >1, Beta<1 or Beta =1. In addition, we also have financial assets that have Beta=0 and Beta<0. We will now see what they mean.

Beta Values Less Than 1

Let us take the first case when the beta value of a stock is less than 1, i.e. Beta<1. Beta is a risk metric. We consider the index to have a beta value of 1, which indicates the market risk. Therefore, if a stock has a beta value of less than 1, it indicates the stock has a lower risk compared to the index.

Also, Beta<1 means less volatility than the market. Hence one may consider such stocks in a portfolio that has less risk exposure. Utility stocks usually have less beta value because they are less susceptible to risk.

But stocks with less than 1 beta value or stocks with low beta value do not perform well during a bull run. The return from them is low compared to the market return.

An investor, therefore, considers all kinds of stock in the portfolio, stocks that consist of both high and low beta values. But an investor may prefer low-beta stocks because of the investment approach.

Beta Values Equal 1

Now, we will talk about stocks that have 1 beta value, or to be precise, beta=1. For such stocks, the risk is equivalent to market risk. In India, we have our stock exchange where the stocks are traded. The benchmark index is NSE. Therefore, we consider the beta value of NSE to be 1. The large-cap company stocks that have high weightage in the index are expected to give returns similar to the index. Hence, these stocks have beta values equal to 1.

Beta Values Greater Than 1

The high beta stocks have beta values greater than 1. Let us consider, stock A is a high beta stock that has beta=1.45. Let us also consider, the market gives a return of approx 20% annually. So, in the first six months, the market grew by 10%. Therefore, stock A, which has a 1.45 beta value, may give an equivalent return of, return R = stock price*14.5% (10*1.45=14.5).

The Beta Values of Indian Stocks
A List of High-Beta Stocks by April 2023

Here is a list of high-beta stocks in 2023. These companies may give ROI as per their respective beta values multiplied by market return over a specific time. But, high beta stocks also have high risks associated with investment in them. These stocks also have high draw-down. An investor must be aware of the risks associated with investing in high-beta stocks.

What is the Advantage of Day Trading High Beta Stocks?

The advantage of day trading high beta stocks is that they tend to have greater volatility than low beta stocks and thus can result in bigger returns. High Beta stocks can be riskier because their drastic price swings increase the likelihood of significant losses as well as gains. However, many traders feel that with increased risk comes the possibility of higher rewards if their trades are successful.

Beta Values Equal Zero

There are financial assets which have a beta value equal to zero. It means these stocks have no beta value and do not grow with the market. These assets appreciate over time irrespective of market movement. Therefore, these assets have negligible risks associated with them. Government Bonds, fixed deposits, and cash or cash equivalents are such assets. These assets are not exposed to market risks. Therefore, conservative investors prefer to invest in these secured financial assets where risk exposure is nil. Many institutional investors prefer to invest in such assets to secure the corpus.

Beta Values Less Than Zero

There are financial assets which have inverse relations to the stock market index. Such financial assets have a negative beta or beta less than zero. Gold is such a financial asset. It is common that when the market becomes highly volatile or starts a downtrend, investors tend to stash their money by buying Gold. Therefore Gold is a good hedging asset too. Gold has a beta<0. When the market starts moving in a bull run, investors sell their position in Gold and start investing in stocks. The price of Gold appreciates over time. Hence, these instruments are good for investment too as it bears negative risk with the market.

Comparison of Stocks with Different Values of Beta in the Stock Market

Beta is an important factor in designing CAPM (Capital Asset Price Management). For this reason, portfolio managers design the portfolio keeping in mind the beta values of stocks. Stocks having a positive beta show that they move in the market direction. For such CAPM designs, the beta value is the investment factor around which investment strategies are centred. Portfolio managers design the portfolio keeping the risk-reward ratio in relation to the beta values of stocks.

A popular beta-centric investment strategy is the smart-beta strategy. In this strategy, the portfolio follows the index but gives risk-adjusted returns. Hence such beta strategies offer attractive options to investors.

Strategic Beta Investment Strategy
Strategic Beta Investment Strategy

Factors Influencing Beta

There are various factors that directly influence beta values. These factors fall into three broad groups. These are operating leverage, financial leverage and the nature of business.

  • Operating leverage – Having operating leverage makes a company more exposed to leverage risks. Therefore high leverage makes a company riskier. Such companies have high beta values. Investment in these companies is risky.
  • Financial leverage -This is also company specific. Financial leverage indicates the amount of debt a company is operating under. The more the debt, the riskier is investment in these companies. These companies have high beta values and offer risky investment opportunities.
  • Nature of business – The performance of a company fluctuates as per the business cycle. The return on investment also varies. Hence, the earning also varies. The beta value of these companies relates directly to the market beta. Therefore, the beta value does not reflect the company earnings but the return on the stock in the stock market.

Limitations of Beta in the Stock Market

Beta has many advantages. Beta strategies are effective too. In spite of all the advantages, using beta poses some disadvantages too. Here are the limitations of using beta in the stock market.

We tend to quantify systematic risk using beta value. But meaning in the stock market also suggests that beta value shows exposure to volatility. High-beta stocks have high-risk exposure and show high volatility too. These stocks show high volatility when company reports come out. Therefore beta value will be high during those periods than at other times. Such values may mislead investors.

Beta measures past performance. But past performance never truly reflects the future. Hence, overdependence on past data may lead to wrong decisions. Only the systematic risk is quantifiable through beta value. Hence the unsystematic risk, which affects the performance of a company may go unnoticed from over-dependence on beta value.

Portfolio managers using CAPM strategies take different measures to overcome these limitations.

Practical Applications of Beta

Investment strategists use beta to create portfolios using the beta value as a reference guide. Such strategies help to create a customised portfolio. Portfolio managers create baskets of stocks using beta strategies. A basket may consist of predominantly low-beta and negative beta combinations for aged and risk-averse investors. Another group may contain mostly high-growth stocks for younger people who are ready to take risks. And there may be another group that contains an equal proportion of high and low beta stock. Diversification of stocks is important to minimize risk exposure. Smart-beta strategies are such strategies we mentioned earlier.

Beta plays a significant role to find investment opportunities. We can use beta value for high-growth stocks like INFOSYS or MAHINDRA & MAHINDRA to compare the actual return and expected return.

Let us consider how investment strategies can be made using beta as a reference.

  • If, actual return<expected return, the stock is underpriced.
  • If actual return>expected return, the stock is overpriced.

Thus, we can find investment opportunities using beta value to find underpriced stock and invest there accordingly. Investors need to check other company metrics for investment decisions. The beta value reference can be used as a screener.

Tips for Newcomers

Newcomers need to understand what is beta in the stock market from the initial stages. Understanding the meaning of beta will help them in a long way. After going through this article a newcomer will have a concrete idea of what is beta in the stock market. But they also need to delve through available materials on beta meaning in stock market for conducting thorough research. There are analytical tools like screeners etc. available to help in conducting research on Indian stocks. In addition, the newcomer may seek professional advice before making investment decisions.

Conclusion

While concluding this article we must say beta plays a great role for investors in making risk-adjusted returns on investment. Also, the use of beta values as a reference to create investment opportunities is no less significant.

This article covers the following key points.

  • What is beta in the stock market?
  • Systematic and unsystematic risks to understand the beta meaning in the stock market.
  • Significance of different beta values.
  • Beta-oriented strategies.
  • Factors that affect beta.
  • Limitations of beta.
  • Using beta for finding investment opportunities.
  • Tips for newcomers.

The newcomers should use beta in making investment decisions because it is a comparatively easy approach to make the right investment decisions. Using beta strategies can help new investors to create a better low-risk investment strategy. With the right kind of diversification, this investment approach can bear fruitful results in the long run.

Finally, beta strategies are smart strategies. An investor can create a basket that can give more risk-adjusted return than the market which will passively follow the market. Therefore, using beta gives far more advantages than its limitations. Newcomers should embrace the beta strategies to extract maximum returns from the stock market.

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Author: Partha Dhar

Partha is a market analyst, FNO analyst, mutual fund advisor, blogger and a full-time trader since 2005. He also teaches market analysis online

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