What is Beta (β) of a portfolio?

What is Beta (β) of a portfolio?: Risk associated with investment: Investments are held in securities with many objectives in mind. From meeting the financial needs to earning the maximum returns, the objectives of the individual investors vary based on their risk appetite and various other factors. But generally, the risk that the investments in the portfolio will not yield the returns expected is very common among the investors. This risk can be classified into 2 types based on the factors that trigger the risk. They are:

  • Systematic risk
  • Unsystematic risk

Beta (β):

Unsystematic risk is the one that arises from a firm’s/industry’s internal factors such as management capability, consumer preferences etc. From the perspective of an investor, unsystematic risk can be reduced by effectively diversifying the portfolio.

But the systematic risk which is associated with political, sociological and macroeconomic-level factors cannot be managed merely by diversification. They hit the entire market as a whole while unsystematic risk is industry/firm specific. The numeric value that measures the degree to which different portfolios are affected by the systematic risks as compared to the effect on the market as a whole is known as beta represented by (β) of a portfolio. It represents the tendency of a security's returns in response to the market movements.

  • Systematic risk of varies from security to security because of their distinct relationships with the market. The beta value indicates the movement in a stock's or a portfolio's returns in relation to that of the market returns
  • Stock market indices such as Nifty and Sensex are used as market return in computation of beta.
  • A higher beta indicates that high systematic risk which means the stock/portfolio’s returns are highly volatile to the changes happening in market and vice-versa.

How is beta computed?

Beta is measured using regression analysis. It is calculated by dividing the covariance the security's/portfolio’s returns and the market's returns by the variance of the market's returns for a specified period. Market return is perceived as benchmark index return such as Nifty and Sensex.

Formula:

Beta (β) = Covariance (X, Y) / Variance (X)

Where X - denotes market returns and Y - denotes portfolio’s/stock’s return

Interpretation of Beta values:

Beta value 1: It is a situation where the portfolio’s returns are in line with the market return. It means that the security’s price moves in almost the same proportion of the market movement. It indicates that the portfolio/stock’s return is as same as the market return or almost close to it.

Beta value less than 1: Beta value less than 1 indicates that the underlying portfolio is relatively less risky/less volatile than the market. Investors with low risk appetite can choose the securities with beta less than 1. But one should always remember low risk comes with low return & vice-versa.

Beta value more than 1: This scenario indicates that portfolio/security is more risky/ volatile than the market. In such case, 1% change in the market results in more than 1% change in the security’s performance. Stocks with beta more than 1 are aggressive in nature. They are suitable for investors willing to take high risk for high returns.

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