Question

Explain the importance of calculating the beta value of individual stocks in estimating the risk tolerance of investors? Explain with examples.

Answer 1

The value which measures the market risk due to the volatile nature of the individual stock is known as beta value. Investors evaluate the stocks’ volatility in relation to the broader stock market by determining the beta value of the individual stock. The higher the value of beta more volatile will be the stock. In other words, the high beta value reflects that if there is a change in stock market then the reflection of such change in the individual stock price will be higher. The risk averse investors should avoid high beta stocks as these stocks involves high risk.

By using beta value of individual stock, an investor may build better portfolio as per their risk tolerance capacity.

To calculate the beta value, investors compare the change in stock’s price to the movement in index throughout the 12-month period. The beta value is expressed as number. The value of beta for market index is 1 and other individual stocks included in the index has different value depending upon the movements in relation with the index.

The stock price with beta value 1:

The change in price of an individual stock with beta value 1 changes exactly in the manner market changes. The investor may add this stock in its portfolio considering that the stock is not much risky.

For example: If the market index increases by 10% then the price of the stock with beta value 1 will also increases by 10%.

The stock price with beta less than 1 or negative:

If the beta value of a stock is less than 1 then it is less volatile, and the investor may include such stocks to mitigate the risk.

For example, if the beta value of an individual stock is negative say -1 then the change in price will be in opposite direction. If the index prices will decrease by 10% then the stock prices will increase by 10% or vice-versa.

The stock price with beta more than 1:

The stock will be more volatile if the beta value is more than 1. This will be riskier for an investor to include such stocks in their portfolio.

For example, the beta value is 2, if the market index price will increase by 10% then the stock price will increase by 20%.

The stock price with beta value zero:

The stock with zero beta value represents that the change in price is independent of the change in market index prices.

Importance of Beta calculation to an investor:

• It helps an investor to design profitable portfolio with moderate risk.

• The investor may select high volatile stocks in the market index.

Drawback:

Beta is calculated based on past performance, so the investor may not always rely on the beta value completely for making investment decisions. There are other factors too which affect the stock price in the stock market.