We use the word Beta in our investments quite frequently. We say that Stock X has a high Beta and Stock Y has a low Beta. Normally Beta is the measure of risk of a stock, or more appropriately a measure of systematic risk of a stock. Beta is very important when it comes to investment or when it comes to managing a portfolio. Different stocks in a portfolio have different betas and the portfolio manager will try to arrive at a target beta for the portfolio by adding or deleting certain stocks from the portfolio.
High beta stocks go up more than the index when the markets are bullish and go down more than the market index when the markets are bearish. Hence the portfolio manager will attempt to add more of high beta stocks when the market outlook is positive and will look to add more of low beta stocks when the market outlook is negative. Let us understand the significance of beta in portfolio management. What is beta in finance and what is the use of beta in portfolio management. For that we first need to understand the concept of systematic risk and unsystematic risk.
Systematic risk and unsystematic risk
Unsystematic risk also called risk that can be diversified. For example, if you are holding on to steel stocks in your portfolio and the risk is high because the steel cycle is going down then what do you do? The steel cycle will impact steel stocks but will not have a major impact on a FMCG stock. Hindustan Unilever and Britannia are not really worried about whether the global steel cycle is turning up or down. Such risks are unsystematic risk as they are unique to a stock or to a particular industry group. As a portfolio manager you can manage this risk by either reducing the composition of steel in your portfolio or exiting steel altogether.
But what is systematic risk? Systematic risk is created by macro factors and impacts all stocks almost uniformly. Therefore they cannot be diversified. For example, if the government has decided to demonetize the currency or to raise interest rates or if the US is at war with Syria then it has its impact on all stocks. You cannot diversify such risk and this is the risk you have to live with. This systematic risk is measured by Beta. Normally, the market expects the fund manager to diversify away the unsystematic risk. Hence the only compensation that is sought by equity investors is for systematic risk. That is why Beta becomes so important in portfolio management and for your investments.
There are different ways of looking at Beta. In Beta what we assume is that the stock price is a dependent variable and the index is the independent variable.
Therefore, the stock price movements are dependent on the index and not the other way round. The relationship between the stock price movement and the index movement is established through the Beta. A beta of greater than 1 is classified as an aggressive stock while a beta of less than 1 is classified as a defensive stock. These aggressive and defensive classifications are at the core of stock selection when a fund manager actually looks to manage the beta of the portfolio.
How is Beta calculated for a stock?
DateIndex ValueStock Price
Day 7-0.28%-1.60%Beta is the slope of the series. The stock price is the dependent variable and the index value is the independent variable in this case. The Beta of 1.23 indicates that for 1% move in the index, the stock price moves by 1.23%. Beta is a measure of systematic risk of the stock
In the above calculation of Beta, the stock is obviously an aggressive stock as the Beta is more than 1. A Beta of 1.23 means that; a 1% move in the index will result in a 1.23% movement in the stock price. Beta is calculated not on the price or the index values but on the daily price returns versus the index returns. Normally, the Beta is calculated by considering price data for much longer periods of time so that the vagaries of the market can be avoided.
How Beta fits into the Capital Asset Pricing Model
Beta forms the core of the CAPM, which is used to calculate the cost of equity, which is an important input for valuation of a stock. Higher the Beta higher is the compensation that investors will expect from the stock and vice versa.
R(e) = Rf + Beta*(Rm – Rf) .. is the core of the CAPM. What it basically says is that an investor in a stock expects the risk free rate of return plus Beta times the market premium for investing in a stock. Beta is the fulcrum in the calculation of cost of equity.