Is It Time To Play Beta?

A stock's beta is one easily available parameter which can be helpful as a gauge of a stock's volatility relative to the broader market or a particular portfolio. Armaan Madhani delves deeper to obtain a better understanding of beta, its merits, demerits and sheds light on how to analyse the market risk associated with a particular stock along with its effect on the generation of respective returns

-  Armaan Madhani

Before investing in a stock, investors study several parameters such as valuation, EPS, ROE, ROCE, dividend history, growth levers, leverage, shareholding pattern, and much more. These parameters no doubt help filter the best opportunities available at a given point of time. However, there are some other important tools that can be utilised along with the above-mentioned parameters to enhance returns. A stock's beta is one such easily available parameter which can be helpful as a gauge of a stock's volatility relative to the broader market or a particular portfolio.

Decoding Beta

The contribution each stock makes to the total risk of a well-diversified portfolio depends on the particular stock's covariance with other stocks in the portfolio. Needless to say, this depends on how each stock responds to changes in the overall financial markets. Volatility is the most common measure to evaluate a stock's potential risk as well as reward. All stocks have a peculiar characteristic volatility that explains the up and down movements in the security's price and historical returns. It is not constant and tends to vary over time for each stock. It also differs depending on the range of the historical period it is calculated from.

However, one of the key determinants of a stock's volatility is the nature of the company's business. Certain types of businesses are simply more stable over time, while others are erratic and prone to dynamic circumstances. While the concept of risk is rather challenging to factor in stock analysis and valuation, one of the most popular and easy measures of risk is beta. This is a statistical measure that compares the volatility of returns on a specific stock to those of the overall stock market or a relevant broad market index.