Risk, together with the willingness to accept it, are two key elements in determining the likelihood of stock market profitability. Beta, which is an analytical technique long used by security analysts and portfolio managers, is one of the best-known methods of measuring such risk.
With an increasing number of stockbrokers and mutual fund managers also utilising beta, many investors are becoming increasingly aware of its use, specifically to its value in the security selection process.
Essentially, beta measures the systematic risk of a security or a portfolio, demonstrating how volatile it is in relation to the entire market or a particular benchmark. If the security has a beta lower than one, it is considered to be ‘defensive’ and less volatile than the market. If the security has a beta greater than one, it is considered to be ‘aggressive’ and more volatile than the market. Contrarily, if a security has a beta of one, it indicates that its price is correlated with the market. The latter implies that there is a direct correlation between risk and reward in the stock market, such that the higher the risk, the higher the reward.
Additionally, beta is the key factor used in the Capital Asset Price Model (CAPM) which is a model that measures the return of a stock. The volatility of the stock and systematic risk can be judged by calculating beta. As a measurement of systematic risk of a security or a portfolio in comparison to the market as a whole, beta differs from alpha. Alpha refers to a measure of performance or active return on investment, indicating when a particular investment strategy, trader or a portfolio manager has managed to beat the market return over a period of time.
Moreover, beta is used as a proxy for risk in valuation models which are used by finance professionals to value stocks. When the output from such models signifies that the stock is cheap, professionals in the industry may consider such stocks as a potential buy. Otherwise, in the case through which the stock is deemed to be overvalued, security analysts and portfolio managers may reconsider their holding in the stock.
Along with other stock market theories, not all finance professionals and academics accept beta as the sole measure of risk within an equity portfolio. One major problem is that several stocks or funds do not move at the same rate within both rising and falling markets. In this regard, beta might vary significantly depending on the period of time in which beta is chosen for tabulation.
Another difficulty is that the beta computation requires either statistical plotting or computer skills that at times may be beyond most of the stockholder’s ability. Nevertheless, investors might still be able to obtain such information from other reliable sources.
Beta is just another method that investors may utilise when picking and retaining stocks and funds. However, as it is considered to be a meaningful indicator of risk, beta offers investors a means through which they may buy securities while simultaneously monitoring and maintaining their own attitudes towards their respective risk acceptance and risk aversion.
Disclaimer:
This article was issued by Andrew Fenech, research analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.