In a nutshell, it is the numerical measure of a company’s risk. It measures the volatility of a company’s share price, relative to the overall market.
Interpreting Beta
To understand Beta further, one must divide a company’s risk into two parts. The first, called ‘Systematic Risk’, is the risk of an entire market declining. Diversification cannot reduce the risk at all. For example, the entire market crash in 2008. The other risk is called ‘Unsystematic’ or ‘Idiosyncratic’ risk and it attaches to a single company. For example, the risk attached to Apple, from iPhone sales.
Beta therefore is a measure of the company’s Systematic risk. It allows you to determine the correlation between the market’s and the company’s prices. By comparing the selected stock’s price with a benchmark index (example: ASX500) over time, you can create a pattern that determines the relativity of the stock price to the index. This allows you as an investor to determine whether you wish to buy a stock that is highly correlated to the market (Beta > 1), or one that is less volatile (Beta < 1).
Example
For example, if WOW (Woolworths Limited) has a Beta of 1.25, it is theoretically 25 percent more volatile than the market. For every dollar that the market’s value increases, WOW will increase by $1.25. Similarly, however, for every dollar that the market’s value decreases, WOW will decrease by $1.25. This stock is suitable for investors willing to take higher risks for higher rewards. Companies in the high-risk sectors, such as the tech industry, tend to have high Betas.
Alternatively, a stock with a Beta of 0.85 will only increase by 85c for every $1 increase in the market value, and vice versa. The stock would be attractive to individuals less willing to take risks. Companies in the low-risk sectors, such as the electric utility industry have low Betas.
Application
Beta is a core component of the CAPM (Capital Asset Pricing Model) formula, that calculates the return on a company’s shares. If you’re looking to purchase stock in a company, it’s Beta would be instrumental in providing a value to the company for a Share Certificate, or a Business Sale Agreement.
Theoretically, a stock’s beta tells the investor how much risk a stock will add or remove from a portfolio. It will only be meaningful if the stock correlates to the benchmark index used in the calculation. It allows the investor to create a custom diversified portfolio for each individual based on their risk aversion.
In practicality, however, a company’s stock is subject to multiple variables, not all of which are captured by a Beta coefficient. A stock with a low coefficient might be less volatile and still be on a long-term downtrend. Adding the stock to the portfolio might actually decrease the portfolio’s performance. Similarly, a stock with a high coefficient that is volatile in an upwards direction can increase the portfolio’s gains. You should consult a brokerage firm or an investment lawyer before making a decision.
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