Risk and returns are two sides of the same coin. It is usually said that one has to take higher risks to get higher rewards. The Indian stock market is filled with investment opportunities. One of them is investing in high-beta stocks.
In simple terms, high beta stocks display higher-than-market volatility, which means that their risk-reward, as well as the risk-loss ratio, is considered to be higher than other stocks.
In this article, we shall take a look at what are high beta stocks, investing in high beta stocks, their advantages and disadvantages, what does high beta tell investors and how does it measure risk. Keep reading to find out!
What is Beta (β)?
Beta (β) is the measure of a stock’s volatility in relation to the overall market. By definition, the market has a beta of 1.0 and individual stocks are ranked according to how much they deviate from the market.
Usually, a stock that swings more than the market over time has a beta of greater than 1.0. However, if it moves less than the market, then the stock’s beta is less than 1.0.
Beta measures risk in the form of volatility against a benchmark. It is based on the principle that higher risk comes with higher potential rewards. High-beta stocks (β >1.0) are considered to be riskier, but tend to provide a higher return potential, while low-beta stocks (β <1.0) are considered to pose less risk, but provide lower returns.
Beta and Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a widely used method for pricing risky securities and for generating estimates of the expected returns of assets, particularly stocks.
It describes the relationship between systematic risk or the general perils of investing and expected return for assets by establishing a linear relationship between the required return on investment and risk.
As mentioned, this formula uses the beta value of a stock to determine the rate of return that shareholders might reasonably expect based on perceived investment risk. This way, beta can impact a stock’s expected rate of return and share valuation.
Beta Values and What They Mean
|1.0||The stock moves in line with the broader market|
|2.0||The stock moves twice as much as the broader market|
|0.0||The stock’s moves don’t correlate with the broader market|
|-1.0||The stock moves in the opposite direction of the broader market|
What are High-Beta Stocks?
The Indian stock market is represented by benchmark indices such as NSE Nifty50 and BSE SENSEX. Beta measures how much a company’s share price will move when the market index moves.
High-beta stocks are those stocks that have a beta greater than 1.0, indicating that they show a greater degree of price movement. However, higher volatility makes them attractive to investors who are looking to make faster gains than the broader market in a short period of time.
Investing In High-Beta Stocks
High-beta stocks call for a high-risk appetite. Investors investing in such stocks need to get comfortable with a high degree of price movement. These swings are not limited merely to the bullish market and can therefore prove to be damaging in the bearish market.
Investing in high-beta stocks calls for investors to have a strong understanding of a company’s fundamentals and its future outlook. Nonetheless, many investors tackle the risk of investing in high-beta stocks with the help of diversification.
Systematic risk is unavoidable in the stock market, however, it can be reduced by investing in low-beta stocks. This is also called ‘risk-hedging’. Another strategy is to invest in undervalued high-beta stocks.
Limitations of High-Beta Stocks
- And, we’ll say it again, high beta stocks offer the potential for larger returns, however, they also come with a higher level of risk. As an investor, you must understand that you stand to lose as much as you stand to gain.
- Beta is a responsive metric. This means that it does not factor in new information. It only shows how much a stock will respond to an index’s movement. It does not indicate whether the stock’s price movement will be upward or downward, thus does not help as much in making an assessment.
- High-beta stocks are not suitable for all investors, especially those who are risk-averse or who are investing for quite a long time, as they may be better served by other types of stocks or assets.
How does beta measure risk?
While beta is a measure of the volatility of a single stock, it is also a measure of ‘systematic risk’ which cannot be mitigated. It is an inherent risk in the market whose movements are led by economic and geopolitical factors, making volatility unavoidable.
Comparing the beta of various stocks can help risk-averse investors understand which stock is more suited to their investment style and thus aid in decision-making. Aggressive investors can check beta values to filter out sluggishly moving stocks and focus on volatile stocks for short-term gains.
Does Beta mean Alpha?
No, Beta and Alpha are two different things. Beta is a measure of volatility relative to a benchmark, while alpha is excess return in relation to a benchmark. Alpha is used to reveal how much active fund managers outperform the index they are trying to beat.
High-beta stocks seem lucrative when one only looks at the potential upside. Investors must bear in mind that downturns are equally catastrophic in terms of losses. One must conduct an in-depth analysis before investing in any stock.
Ultimately, it is important for investors to make a distinction between short-term risk — where beta and volatility are useful — and longer-term fundamental risk where big-picture risk factors give a better idea.
A high beta stock may mean price and volatility over the near term, but they don’t always rule out long-term opportunities.
Also Read: The Ultimate Guide to Portfolio Rebalancing
High beta stocks are those stocks that have a higher volatility compared to benchmark indices. The volatility of these indices is considered to be 1.0, while high beta stocks have a volatility of greater than 1.0. These stocks have the potential to give high returns, but they also carry a high amount of risk.
High-beta stocks are generally risky but provide higher return potential. In contrast, low beta stocks pose a lower risk, but come with lower returns. High beta stocks outperform in bull markets, but can underperform in bear markets.
Usually, experienced investors with a high risk appetite invest in high beta stocks. These investors are keen to bag capital gains and are looking to make a quick buck from fluctuating share prices. These stocks require a great deal of active management because of their market sensitivity.
High beta stocks generate higher returns over a period of time. In fact, their returns are much higher than the prevailing inflation in a country, helping them act as a hedge against inflation. However, high beta stocks are not suitable for all investors and require extra caution.
High-beta stocks are more sensitive to changes in the broader market, and a downturn in the overall market can hit high-beta stocks hard. Moreover, they cannot be evaluated solely on their investment value and demand extra caution.