The stock market has its own language, which sometimes sounds as if some space scientists were trying to establish a communication link with Martians.
Did you know that stock earnings consist of beta and alpha? Or there is something referred to as theta, which measures the rate of decline in the value of an “option” due to the passage of time? These are just a few examples. The market keeps on developing new terms at a rate that could leave even space scientists far behind. To get a grip on the basics of market talk, every investor needs to keep his brain cells active.
Johnny: I know there are a lot many things to talk about but I can focus only on one subject at a time. It would be great if today you could tell me about beta.
Jinny: Those who have studied finance are well versed with beta (b) as a part of the equation used in capital asset pricing model (CAPM). However, without going into the nitty-gritty of CAPM, I would tell you about beta in the language you can best understand. Although we can talk about beta in respect of other financial assets, say, bonds, it is easier to understand this concept in respect of stocks.
To put it simply, beta is the return generated by your stocks due to market forces. It is the return your stocks earn simply because they are part of the market. You could think of the market as an ocean and your stocks as a boat.
When the market tide comes, it simply lifts all the boats. Your stocks also benefit from the high market tide. But there are two things we should always keep in mind while talking about beta. First, the tide that lifts the boat can also sink it. In a way, the fate of your stocks is tied up with the fate of the broader market. It rises with the market but it could also fall with the market. Second, the market tides do not lift every stock equally. Some stocks called high beta stocks rise or fall more than the rise or fall of the broader market. Similarly, there are low beta stocks that rise or fall less than the broader market. We could say that beta denotes the volatility of a particular stock, that is to say, how much a particular stock is likely to rise or fall in comparison with the broader market. In other words, high beta stocks are more volatile than low beta stocks.
Illustration: Jayachandran / Mint
Johnny: High beta, low beta—sounds as if we were talking about magnetically charged particles. Can you elaborate it further by taking an example?
Jinny: Think of a market index, say, the S&P CNX Nifty, as a representative of the broader market. Every rise and fall in the Nifty would have some correlation with the rise and fall of your stock, which we express in terms of beta. Suppose you own a stock that has a beta of 1.5. Then whenever the Nifty rises by 10%, your stock is likely to rise by almost 15%. Likewise, whenever the Nifty falls by 10%, your stock is likely to fall almost by 15%. A stock with a beta less than one would rise and fall less than the rise and fall of the broader market. For instance, if the beta of your stock is 0.5, then for every 10% rise and fall of the market, your stock is likely to experience a rise and fall of 5%. Theoretically speaking, a beta of zero would denote that a particular stock is not affected in any way by movements in the broader market, and a negative beta would mean that a particular stock moves in the opposite direction to the broader market.
If the broader market is falling, a stock with negative beta is expected to rise, and vice versa. In reality, it is tough to find stocks that have negative beta in relation to the broader market. Some stocks may temporarily exhibit negative beta, but in the long run stocks go along with the market, some steps ahead or some steps behind.
Johnny: What purpose does beta serve in how we decide to make investments?
Jinny: You can use beta for managing the overall risk of your portfolio. You can know about beta of a particular stock from the website of stock exchanges or from any good website providing information about company stocks. A portfolio consisting of only high beta stocks obviously has a chance to earn better returns than the overall market but it also carries more risk. Once you know about beta of different stocks, you can use it for constructing a portfolio that suits your risk appetite. But I would like to add a few words of caution. You should know that beta is calculated by using a regression analysis against a particular stock market index, which means that the entire process relies on past data.
Sometimes the past may not provide the right guidance for the future.
Johnny: Sometimes we may fail, Jinny. But we should remember that success comes from experience and experience comes from failures.
What: Beta denotes correlation of a stock price with movements in a market index.
Why: Knowing about beta is useful because it helps in managing the overall risk of a portfolio.
How: Beta is calculated by doing regression analysis against a stock market index.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com