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BETA AS A MEASURE OF RISK WHAT IS BETA?

The degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market return. It gives a sense of the stock's market risk compared to the greater market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. in times of a bull market (rising markets) investors should hold stocks with a high positive beta factor since they should outperform the market. However in times of bear markets (falling markets) then investors should target low beta stocks since they should outperform the market. Illustration: Say a company has a beta of 2. This means it is two times as volatile as the overall market. Let's say we expect the market to provide a return of 10% on an investment. We would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company. ESTIMATION OF BETA To estimate beta, we need a list of returns for the asset and returns for the index; these returns can be daily, weekly or any period. Then one uses standard formulas from linear regression. The slope of the fitted line from the linear least-squares calculation is the estimated Beta. The yintercept is the alpha. FORMULA Beta is calculated as:

Where, Y is the returns on your portfolio or stock - DEPENDENT VARIABLE

X is the market returns or index - INDEPENDENT VARIABLE Variance is the square of standard deviation. Covariance is a statistic that measures how two variables co-vary, and is given by:

Where, N denotes the total number of observations, and arithmetic averages of x and y.

and respectively represent the

In order to calculate the beta of a portfolio, multiply the weightage of each stock in the portfolio with its beta value to arrive at the weighted average beta of the portfolio. ADVANTAGES OF BETA To followers of CAPM, beta is a useful measure. A stock's price variability is important to consider when assessing risk. Besides, beta offers a clear, quantifiable measure, which makes it easy to work with. It's a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.

DISADVANTAGES OF BETA BETA is a historical measure of a stock's volatility. Past beta figures or historical volatility does not necessarily predict future beta or future volatility. In other words, if a stock's beta is 2 right now, there is no guarantee that in a year the beta will be the same. Another troubling factor is that past price movements are very poor predictors of the future. Betas are merely rear-view mirrors, reflecting very little of what lies ahead. The beta measure on a single stock tends to flip around over time, which makes it unreliable. Granted, for traders looking to buy and sell stocks within short time periods, beta is a fairly good risk metric. But for investors with long-term horizons, it's less useful. As beta is found by comparing the volatility of a stock to the index, beta only takes into account the effects of market-wide risks on the stock. The other risks the company faces are firm-specific risks, which are not grasped fully in the beta measure. So, while beta will give investors a good idea about how changes in the market affect the stock, it does not look at all the risks the company alone faces.

The following is a chart of IBM's stock for the trading period of June 2004 to June 2005. The red line is the IBM percent change over the period and the green line is the percent change of the

S&P 500. This chart helps to illustrate how IBM moved in relation to the market, as represented by the S&P 500 during the one-year period.

On June 8, 2005 the beta for IBM 1.636, meaning that up to that point, IBM had the tendency to move more sharply in either direction compared to the S&P 500 - and the chart above demonstrates IBM's tendency for higher volatility. When the market moved up IBM (red line) tended to move up more (see the Oct-to-Dec range), and IBM's stock fell more than the market when it declined (see the Jan-to-Mar range). The large drop in IBM stock from Mar to Apr 2005, while coinciding with a smaller drop in the S&P, resulted from a firm-specific risk: the company missed earnings estimates. By showing IBM's behavior over this period, this chart demonstrates both the value that comes with the use of beta and the caution that needs to be shown when using it. It helps measure volatility, but it is not the whole story.

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