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Understand risk, understand beta

August 05, 2009 14:04 IST

We all know that stocks or equity funds are highly volatile. It is not uncommon to see the price of a stock going from a high of Rs 100 to a low of Rs 50 and vice versa.

Different stocks and funds have different levels of volatility. For example, large-cap stocks and funds are less volatile than the small and mid cap stocks and funds. Even stocks and funds operating in the same sector have different levels of volatility. For instance, growth stocks are more volatile than value stocks.

So how do you tell how volatile a fund is? What are the effects of volatility on the returns? Let us see.

Welcome to the world of Beta: If you think beta is not a Greek alphabet, you are not totally wrong. Besides the Greek alphabet, beta also denotes the volatility of the fund (stock) as compared to the market or its benchmark.

Suppose there are two funds, one having a beta of 2 and other with the beta of 1.5. Now if their benchmark index rises by 1.5%, the fund with the beta of 2 will show an appreciation of 2% and the fund with the beta of 1.5 will show an appreciation of 1.5%.

The same relationship is evident when the benchmark index goes down. Thus we can safely conclude that beta is a numerical measure of the volatility of a fund or stock in comparison to the market. If the value of beta exceeds 1, the fund (stock) is highly volatile as compared to the market and vice versa.

Effects of beta on the investment returns: Beta denotes the basic compromise between reducing risk and maximizing return. While a fund (stock) with low beta will protect you against market volatility, its return will also be lower than its competitors. A fund having the beta of 1 will actually move in the same direction as the market.

On the other hand, a fund whose beta exceeds 1 will be lot more volatile than the market and will give very high returns during the bull run, but will crash significantly during the bear run. On the other hand, the fund with beta below 1 will show the reverse effects.

Drawbacks of beta: How effective beta is will depend on the index used in computation of beta. E.g. beta of BSE-IT index will differ from the beta of BSE-FMCG index. Also, it is useless to calculate the beta of a large-cap fund with reference to mid-cap index, as both the fund and the index will not move in the same direction.

If the fund or company is new, beta will fail here as beta uses the historical data and these entities have inadequate price history. Also, if the existing company has undertaken massive loans for its expansion plans, beta is unable to capture the complete risk taken. Moreover it is not the assured predictor of future performance.

As an investor, you must understand the risk you are taking in order to get good returns. To get an idea of the risk you are taking with the investment, you must be aware of the beta of the stock or fund. Low beta implies low risk and thus volatility and consequently low returns and vice versa.

Different sectors and funds have different levels of volatility. So their beta values will differ. However, beta should be used along with other factors like management expertise, future prospects and your investment horizon. The longer your investment timeframe, the lesser the volatility, and thus lower the risk.

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