Nowadays, it is not vital to know what is going in life. Everyone wants to realize the risk they are taking. However, the risk is becoming a significant part of our lives, whether you are deciding to buy a car, find a new house, and find a new job. No one wants to trust these decisions. We all need a baseline idea to understand the risk.
However, it becomes difficult to face challenges in the financial world. If you are diving into the investment world, then you have come to the right place. It is vital to understand the risk while investing. Here in this article, you will be able to understand the beta to have a grasp of risk. This article is a comprehensive guide of beta in financing. But before moving further, it is vital to know the definition of beta.
What is beta in finance
It is a procedure to measure the volatility, systematic risk of a security or portfolio compared to the market. Moreover, beta helps to describe the relationship between the expected return for stocks and systematic risk.
The capital asset pricing model is widely known for pricing risky securities and generating estimates of stocks’ expected returns. A capital asset is also known for calculating the cost of equity.
Beta coefficient = Covariance of market return with stock return/Variance
Where Covariance is: How changes in stock return are relating to changes in the market return.
Variance is known as How far the market data points spread out from their average value.
Interpretation of beta coefficient:
- When the beta coefficient value is equal to one, then it is exactly as volatile as the market.
- If the value is more than one, then it will be more volatile than the market.
- If the value is less than one, then it will be less volatile than the market.
- The price is equal to zero shows that it is not related to the market.
- Moreover, if its value is less than zero, it will be negatively correlated to the market.
How to calculate beta in finance?
We can use regression analysis to calculate beta. Above we showed the formula for calculating beta. But you can also calculate beta by downloading an Excel beta calculator and can measure beta on your own. Moreover, you can also calculate beta by using the slope function in Excel. Below we are going to show you some steps of calculating the beta on excel.
- Firstly, access the prices of the stocks every week.
- Access the weekly prices of the market index (i.e. S&P 500 Index).
- Now calculate the returns of the stocks every week.
- Further, calculate the returns of the market index every week.
- Lastly, select the returns of the market and stocks by using the slope function.
- Now the output you get from the slope function is the beta.
Numerically, the value we get through these steps will represent the tendency for a return to respond to various changes in the stock market.
Examples of beta
High beta: A company having a beta value greater than one is more volatile than the market. For example, a company with a beta value of 1.85 would have returned 185%.
Low beta: A company having a beta value lower than one is less volatile than the stock market. For example, a company that has a beta value of 0.75 would have returned only 75%.
Negative beta: A company having negative beta value is negatively correlating to the stock market’s returns. For example, a company that has a beta value of -0.3 would have to return -3%.
How Beta Works
Compared to the systematic risk of the entire market, beta is known to calculate a particular market’s volatility. Moreover, according to statistical terms, it represents the line’s slope through a regression of data points. However, in the financing, each data point represents a particular stock return.
Beta response to the swings in the market and effectively describes the activity of security return. Calculating a beta is to divide the product of the covariance of the market return and the security return by the variance of the market return around a specific time.
The beta calculation guides the investors to understand the direction of a stock moves as the rest of the market. It also helps the investors know how risky-a stock is relative to the rest of the market and provides insights into its volatility. For example, to calculate a bond ETF beta, you would not be using the S&P 500 as the benchmark.
Ultimately, beta helps the investors to calculate how much risk a stock is adding to their portfolio. Deviated goods from the market do not add many threats to a portfolio and do not increase the potential for greater returns.
Investors should have a high R-square value to create a benchmark compared to a particular stock. R-square is also known as a statistical measure that shows the percentage of security historical price movements. Moreover, the beta measurement will improve using the high R-square value to determine the degree of risk and its standard.
A stock investor split risk into two categories that make it easier for a stock investor to think about it. Systematic risk is known to be the first category risk, which is also known as un-diversifiable risk. For example, the financial crisis in 2008 is an example of systematic-risk.
Unsystematic risk is known to be the second category risk and as diversifiable risk. However, the Lumber Liquidators announces to sell hardwood flooring with a dangerous level of formaldehyde is known as the un-diversifiable risk.
What do you mean by Asset beta and equity beta?
Equity beta or stock beta is the same thing. It is the risk of return for a stock, taking into account the impact of the company leverage from its capital structure. Equity beta compares between market risk and stock company risk.
The levered beta includes two types of risk, business risk and risk that comes from taking on debt. It is similar to equity beta because it is the risk(volatility) of equity-based on its capital structure.
Asset beta helps the investors by showing them only the risk of the company relative to the market. Moreover, It does not show the stock risk, but it shows business risk.
Difference between levered beta and unlevered beta
Levered beta is known to be equity beta and offers the measurements that compare the broader market to a company’s volatility. Moreover, it includes the impact of a company’s capital structure and measures risks. Investors using levered beta(equity beta) can access sensitive security to macro-market risks.
Each company’s capital structure is different from others. An analyst must be eager to look at the company’s asset risk and the percentage of equity funding or its debt. As much high a company will take a risk, that means higher the debt or leverage, the company’s more earnings will make through the company’s committing to serve the debt. It increases the risk, but it also raises the company’s future income. Therefore, removing financial leverage can help the investors to find the risk through beta.
Pros and cons of beta in finance
Beta comes with both advantages and disadvantages. If beta is helpful for us, but it also has some limitations. Below we are going to show you some pros and cons of beta in financing.
Beta is very useful. While accessing the risk, a stock’s variability is vital to consider. Beta plays the role of proxy for the threat if you are thinking about risk as to the possibility of wares losing its value. Moreover, it will also make plenty of sense. Start thinking about a modern technology stack with a price that bounces up and down more than the market.
However, beta offers quantifiable and measures that are easy to work. There are variations in beta value depending on things such as time and market index. The notion of beta is straightforward. Lastly, beta is helpful for the investors to capture risk in their companies.
Beta offers some useful information when calculating a stock, but it has some limitations also. While using the Capital Asset Pricing Model (CAPM) determines the short term risk and analyzes the volatility in the stock market. However, sometimes it becomes less meaningful for investors looking to predict a stock’s risk movements because historical data points are useful in calculating beta value.
The bottom line is that beta is vital for investors to understand the difference between short-term and long-term risks. However, high beta does not rule over long term opportunities. It only means the price volatility over the short term. We hope that this article will help all the investors to understand the beta in finance.