Wednesday, August 31, 2011

Stock Beta

If market falls investors can be certain to make loss. It rarely happens that the index is falling and a particular portfolio is making profits. Generally all stocks follow the index. The value of beta decides how sensitive a stock is to every movement of index. But it may happen that though the index is going up a particular stocks (say X) has gown down.

Yes this is also possible, and this is what we call as avoidable risk or diversifiable risk. If person has only one stock then he may face loss irrespective of index performing well. Such negative movements of a particular stock can be neutralized by diversifying investments. Means spreading money in several stocks instead of only one or few.

Diversification and risk management
As discussed above, we have observed that by diversification investors can lower the magnitude of their loss. Investors who want to play safe shall invest more in stocks which have a value of beta near to one. But if investors are interested to take risk and would like to investor for rapid growth then they should select stocks with beta value like 1.5 to 2.

If one has more stocks in portfolio comprising of stocks with beta value higher than one than average beta of their portfolio will also be higher than one.
It is also important for investors to know that how best their stocks are capable of performing. To know this we have to use the principle of CAPM (Capital asset pricing model) to predict expected returns form assets (like stocks). CAPM says that expected returns from a diversified portfolio equals risk free return plus risk premium.

Expected return = Risk free return + risk premium.
Ri = Rf + β x (Rm-Rf)
Ri = Expected return per annum
Rf = Risk free return per annum
Rm = Expected return on market portfolio (sensex say) per annum
β = sensitivity index of stock as compared to index (sensex say)

Market rewards investors for taking un-avoidable risks. The reward is equal to β x (Rm-Rf) called as risk premium. The risk premium is over and above the risk free rate of return.

Risk free return = 8% (government bonds);
Rm of Sensex rising form 17000 to 17200 levels in one year = 200/1700 = 12%.
Beta (β) of portfolio (not individual stock) is 1.5,
Expected return of portfolio will be equal to 8% + 1.5 (12%-8%) = 14%.

It must be noted that CAPM is valid only for portfolios (combination of stocks) and not on individual stocks. Logic is simple; if an investor has invested in only one stock then he is certain to make loss if the price of that stock falls. But in case of a diversified portfolio, investors can make profit irrespective of a particular stock performing badly.

Diversifiable and non-diversifiable risks
We have seen that CAPM is valid only for portfolios (group of stocks) and not on individual stocks. To understand this we must understand the concept of diversifiable and non-diversifiable risks. As a lay man one can say that diversifiable risks are those risks linked with stock that can be avoided by investment diversification.

If an investor has not diversified his investment among several stocks than rule of CAPM is not valid and market cannot compensate the investor for the risk taken. Market rewards an investor by paying risk premium in addition to the existing risk free rate. Risk premium is equivalent to β x (Rm-Rf). So what does this lead to, does it means that by investment diversification an investor can avoid all risks? No by diversification one can avoid only diversifiable (avoidable) risks but still the threat of non-diversifiable (non avoidable) risks exists.

Stock Investment risks = diversifiable risks + non-diversifiable risks
Let us assume for a moment that non-diversifiable risks do not exist. In such a situation an intelligent investor will buys all stocks of an index. In this case the performance of the portfolio will be exactly equal to the performance of the index. All movements of the index will be exactly replicated by the portfolio. If sensex moves up by 9.8% then valuation of the portfolio will also go up by 9.8%. Such a portfolio has a beta equal to 1.

But it must be noted that if sensex is making a loss then portfolio will also make loss. A perfectly diversified portfolio is one which can exactly replicate the index but it does not mean that there is no risk. There is still a risk of loosing money. If index will fall even the portfolio that has beta equal to 1 will incur loss. But what are these avoidable risks?

These risks are company/ sector specific risks like lock-out, accident, low demand of product etc. But many a times we hear that a particular mutual fund (good example of portfolio diversification) has out performed the index. How does it happen? This happens due high beta stocks comprising that portfolio.

Examples of non-avoidable risks are like hike of crude oil prices, financial crisis in US, political destabilization at center etc. These events will harm the performance of all stocks irrespective of their product, sector or region. Market pays premium to investors (who are already diversified) who takes non-avoidable risks by investing in stocks. This is also another very valid reason why long term investment is preferred in stock market. If there will be loss one year due global problems than it will take time for market to revive and come back to profitable levels.

Long term investors should spread their portfolio so that it can replicate the performance of index. In a growing economy like India, China, Brazil, Russia etc, index will go up in long run. If one has a portfolio which replicates the index then the investor can be certain to make profits. But the magnitude of profit / loss is dependent on the value beta of the portfolio. People interested in big gains can invest in stocks wit large beta value.
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