Beta (beta coefficient or β) is a finance term that represents risk of a financial instrument. In simple terms, it is a numerical value that depicts how volatile are the prices of financial instruments.
Beta is the standard deviation or volatility of prices around the mean. Generally, a Beta less than 1 shows that the investment instrument is less volatile while a beta that is greater than 1 shows that the investment instrument is highly volatile.
How Beta Is Calculated?
In order to calculate the beta of an asset, the variance of the market returns and covariance of the market and individual asset returns should be known. Once you know these two figures you can calculate the beta using the following formula.
Beta = Covariance (rmarket , rasset ) / Variance of rmarket
Another way to calculate the beta is by dividing the standard deviation of asset returns by the standard deviation of market returns and them multiplying the value by the correlation of the returns of the asset and the market.
Beta = (S.Dasset/ S.Dmarket) x Correlation(rmarket , rasset)
A number of online resources such as Yahoo! Finance, Bloomberg, and Google Finance quote beta of different securities listed in major stock exchanges around the world.
Importance of Beta for Investors
Beta is one of the tools that help investors optimize return potential of their investment portfolio and also limit the possible losses. Ideally, a balanced portfolio should have beta that is exactly 1, which is the risk of all investable assets in the market. However, this is not possible in practice, and so investors that aim to create a balanced portfolio try to keep the beta of the investment portfolio as close to 1 as possible.
A higher beta means that the price movements of the asset are highly correlated to the market, while a lower beat means that the assets have low correlation with the general market. The more risky an investment asset, the higher the beta and greater are the chances of losses. However, assets with a high risk also have the potential of providing greater returns to the investors.
When the portfolio asset has a beta that is close to 1, it moves in a similar manner to the market. If the beat of a portfolio is greater than 1, the asset price gains will be higher during upward trending market. On the other hand, the losses will also be greater in case of downward trending market.
How to Best Make Use of Beta to Make Investment Decisions?
Investors must create an investment portfolio consisting of different betas with the net beta being close to 1. It’s important to include individual assets that have both high and low beta. Assets with a high beta such as stocks will provide above average returns on investment during market upturn, while those having low beta such as gold will act as a hedge and offset the losses during market downturn.
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