Pegging Risk to Uncertainty

Beta measures the tendency of stock prices to respond to swings in the market. Should investors use it to guide their stock picking?

By Isankya Kodithuwakku.

Published on March 13, 2015 with No Comments

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In the current extremely volatile Sri Lankan market, an investor would be better off holding stocks with beta value less than 1 rather than those above 1. Atchuthan Srirangan comes to this conclusion after compiling all Colombo Stock Exchange listed stocks by beta value as of the fourth quarter of 2014 in a note published by GIH Capital.

Calculated using regression analysis, a company’s beta value is a measure of its volatility or systematic risk compared to the market as a whole.For instance, a stock with a 1.2 beta would be 20% more volatile than the market, while a stock with a 0.75 beta would be 25% less volatile. Hence, in a volatile market with frequent downtrends, as in Sri Lanka right now, holding a portfolio strong in stock with beta less than 1 is a safer bet, as this means the portfolio would not fall as much as the market would. On the flip side, though, this also means the portfolio would not rise as much as the market, if the latter rises. “There’s less of an upside,” Atchuthan says. “But in these risky times, minimizing the downside is what’s important.”

The beta value can also be equal to 1, which means the stock’s price volatility is similar to the market index. A beta value of less than 0, which is quite rare, indicates the stock will move in the opposite direction to the market. Since increased volatility of a stock price translates to more risk to the investor, stocks with beta above 1 can be expected to have greater returns, while stocks with beta below 1 can be expected to have lesser returns.

In a market with a clear upward trend, an investor would be better off holding stock with beta above 1, as his portfolio would rise a lot more than the market would. But this also carries a risk, as a sudden downturn in the market would lead to a far greater drop in the investor’s portfolio’s value. Ultimately, as with all investing, a balanced portfolio is an investor’s safest bet. “Ideally, you shouldn’t hold stocks of just one beta range, as it all depends on the state of the market,” says Atchuthan. “You should try to diversify as much as possible in order to ensure you can benefit from any given situation in the market.”

Beta is a statistic based on historical performance and isn’t an indication of future performance, as it does not take into account the strengths and weaknesses of companies or their share prices. It should not be a lone deciding factor of stock picking. If at all, smart investment managers should be trying to buck the market trend.

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