Understand beta before you buy stocks!

So, how do you understand how volatile a fund is? What are the effects of volatility on the returns?

The world of Beta

Beta, in the financial world, denotes the volatility of the fund (stock) as compared to the market or its benchmark. That is: 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 per cent, the fund with the beta of 2 will show an appreciation of 2 per cent and the fund with the beta of 1.5 will show an appreciation of 1.5 per cent. 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 maximising return. While 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 the beta is will depend on the index used in computation of beta. That is, beta of BSE-IT index will differ from the beta of BSE-FMCG index.
- 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. 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.

You must understand the risk you are taking in order to get good returns. This requires that you understand the beta of the stock or fund. Low beta implies low risk and thus volatility and consequently low returns and vice versa. However, beta should be used along with other factors like management expertise, future prospects and your investment horizon - longer your investment timeframe, lesser the volatility and in turn the risk.