Understanding beta and how to use it

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Understanding beta and how to use it

SRIWIPA SIRIPUNYAWIT

Three weeks ago we discussed Net Asset Value and its use. This week we will move on to the another frequently used investment term, beta ratio. Some people may believe that such terms are for brokers and investment professionals, but in fact beta is easy to understand and very valuable to apply.

Q: What is beta ratio?

A: Basically, beta is a measure of market risk and stock price volatility in relation to the rest of the market. It usually indicates the movement of a stock's price relative to the overall market. Additionally, it is used to assess the level of risk and volatility of a mutual fund.

Q: How is beta calculated?

A: Usually, the beta ratio is calculated by a regression analysis method. In general, a value of 1 is assigned to represent the entire market's volatility. Each stock and each mutual fund is also granted a beta value.

When a stock or fund holds a beta greater than 1, that means it has greater price volatility than the overall market and thus is more risky. When the stock or fund has a beta of 1, it means the price fluctuation is at the same rate as that of the broader market. And when the stock or fund holds a beta of less than 1, the price volatility is less than the overall market's or it is less risky.

Q: How can we use beta?

A: Beta should be used as a tool to refine investors' choices before making an investment decision. Investors should pick stocks or mutual funds that possess levels of risk and volatility that suit their risk appetite and expectations.

However, beta can be misleading. For a start, the calculation is usually based on historical data, which of course cannot always guarantee how an investment will perform in the future.

Therefore, many experts say that beta is best used to measure the risk and volatility of the price of a stock or mutual fund in the short term rather than the long term.

In addition, there isn't only one way to calculate beta value, and some sources may base their calculations on different periods of data, which lead to different results. In such cases, investors should use the same beta source when assessing different stocks. Make sure before you begin that the source is reliable.

Q: How to select investments based on beta?

A: Basically, investors should select the stocks or funds with beta values that suit their risk profiles. Those who are conservative or risk-averse may want to go for the stocks or funds that hold a lesser beta when compared to the overall market. Those who are willing to take on higher risk might be comfortable with stocks or funds that possess higher beta than that of the entire market.

Higher risks usually mean higher returns. Stocks with high beta should thus generate higher returns than the overall market and vice versa.

Sometimes, investors may select stocks holding high beta values when they are bullish on the market in order to gain when the market is up. And, they will opt for stocks with lower beta when they expect the market to fall, since that means the loss should be less than that of the entire market.

Q: How to get the beta?

A: Usually professional stock analysts and fund managers have lists of beta ratios for the stocks they invest in. Investors should always ask for the figures before making their decisions. Sources such as Reuters and Bloomberg always have the data available as well.