Investors should choose shares with different beta for their portfolios and arrive at a target beta for the portfolio which suits their risk preference
The term ‘beta’ is being used in different contexts across different domains. In investment science settings, however, the term is more relevant in assessing the risk associated with the asset. Understanding beta can certainly help investors to predict reasonably how a share is likely to perform in the near future. Let us discuss beta in detail.
What is beta?
Basically, beta is a statistical term and it is used in investment science to measure the volatility of a share or fund relative to the market index or the benchmark index. The value of beta of a stock or fund is always mentioned against its benchmark and the beta of benchmark or market index is always equal to 1. To have a better understanding of beta, one should know about systematic risks and unsystematic risks.
What are systematic risks?
Systematic risks are those risks arising out of macro factors and impact all the shares across the market almost in the similar manner. For example, announcements by the government on demonetization of the currency or lower interest rates or if the US is at war with a certain country, etc., can all definitely have a big impact on all shares. Thus, such risks cannot be avoided and diversified and as an investor one needs to live with it. So, this systematic risk is measured through a proxy known as beta.
What is unsystematic risk?
Contrary to systematic risk, unsystematic risk can be diversified. So they are also known as diversifiable risk. For instance, you are holding cement shares in your portfolio and the risk is high owing to lower construction activities and the business cycle is going down. Though the cement cycle will impact cement stocks, it will not have a major impact on pharmaceutical shares. Such risks are unsystematic risks because they are unique to a particular segment or industry. As an investor, you can manage this risk by either reducing your holdings in cement stocks or probably exiting the cement sector and buying shares of companies from some other segments like pharma, telecom, etc.
How to interpret beta
There are different ways of looking at beta. Beta is calculated using regression analysis wherein the share price is a dependent variable, and the market index is the independent variable. So, the share price movements depend upon the market index movements. Beta of a share’s return responds according to swings in the market return. A beta of 1 indicates that the share price will move in exact tune with the market index whereas a beta of less than 1 means that the share will be less volatile than that of the market index.
A share with a beta of zero shows that its returns are not correlated with the index movement. Sometimes, beta can also be a negative which means that the share generally moves in the opposite direction of the market index or benchmark. Generally, shares with a beta of more than 1 are considered as an aggressive share while a beta of less than 1 is classified as a defensive stock. These aggressive and defensive classifications are at the core of share selection, according to the risk appetite of the investor.
To conclude, beta is a measure of systematic risk of a share. You should choose shares with different beta for your portfolio and arrive at a target beta for the portfolio, which suits your risk preference.
The writer is a professor of finance and accounting, IIM Tiruchirappalli