Have you ever wonder why some stocks seem to fall a more when the index is down as compared to others? Or why is it when an index is up say 1%, a stock can be rising more than 1%?
With modern day technology, this can be numerically calculated through an indicator known as the Beta (β) of a stock.
Beta refers to the volatility of a stock in response to the overall changes in the market. (Market being a benchmark index such as STI or S&P500)
What is BETA (β)?
Beta refers to the volatility of a stock in response to the overall changes in the market. It is measured as a single digit. (Usually 1 , 0.9 , 1.5 etc.)
A stock with the beta of 1 would indicate that theoretically, the stock is as volatile as the market itself. If the stock has a beta measurement of 0.9, this would indicate that the stock is theoretically 10% less volatile than the market. Likewise, with a beta of 1.5, this would indicate that the stock is very volatile and likely to be more than 50% more volatile than the market.
When we look at the idea of the “Market”, an index is often used. As a case study, if we’re looking at beta for Singapore Exchange Limited (SGX : S68), the index which it is being compared against would be Straits Times Index. In this case, the beta of S68 is 0.23 which indicates to that this stock is highly stable and possibly 80% less volatile than the STI. As a long term investor, this is good news to me as it tells me that the stock is likely to hold its ground well during a correction or crash. (We will explore S68 as a case study later on.)
How is BETA(β) calculated?
I’ve attributed the difficulty of calculating beta to something along the lines of rocket science. While this is something that I myself haven’t fully mastered, beta is something which computers can calculate for us based on modern day technology.
For readers interested in the exact calculations of the beta formula, you can refer to this website which I’ve found to be the most comprehensive.
Rather than learning to calculate Beta manually, what’s more important for investors is…
Understanding BETA(β)
Understanding the concept of is beta can give investors a better understanding of volatility within the market.
It is safe to say that if you are an investor with lower risk appetite, you would want to look for stocks which have a lower BETA.
Likewise if you are a short term trader looking for swing highs and lows, a stock with commands a higher BETA would be one which is considered “ultra-responsive” to market conditions.
As a theoretical visual representation, here are what stocks with the respective beta of 0.8 , 1 and 1.5 may look like on an upward trending stock.
Though this representation is not drawn to scale (and certainly not reflective of real stock price movements), what it illustrates is how in theory, stocks with higher beta would tend to experience more drastic levels of volatility whereas stocks with lower beta experience more compact levels of volatility.
How can I use Beta to make better investment decisions?
Broadly speaking, the theory behind using a stocks beta to evaluate its volatility makes plenty of sense as it is calculated based on historical data (usually over a period of 5 years). However as with all indicators, the beta is an indicator of volatility and in no way an indicator of future profitability. Therefore what it can tell you is how risky your investment is but it will in no way tell you if your investment will be profitable in the future.
While longer term investors may use beta to evaluate risk, short term traders have plenty to take away from understanding beta as well. For example, in a bull market, a 1.5β stock is likely to give you gains beating that of its compared benchmark index by close to 50% however in a bear market, the very same stock will likely deliver 50% more losses. Therefore it is crucial to know which direction the market is going in order to know which position to take (either long or short).
With this, lets take a look at some case studies.
Case Study 1 – Singapore Exchange Limited (SGX : S68)
Singapore Exchange currently has a beta of 0.23. With the knowledge from above, this in theory should indicate that this stock is highly resilient despite market conditions as in bear market, the stock is likely to experience 80% less volatility than compared against the benchmark STI.
What it also means is that in a bull market, then stock is also expected to rise but probably 80% slower than the rest of the market.
If we compare the price action of Singapore Exchange during the events of March 2020, at its peak of $9.38, it corrected to a low of about $8 a month later which equates to about 15% decrease.
Comparatively, the STI experienced a decrease of almost 30% in the same time period.
In this example, it correctly shows how the concept of beta was able to illustrate lower volatility of Singapore Exchange as compared against the STI.
However, if we look forward in time, after Singapore Exchange corrected from the 15% decrease, it reach a high of almost $10.40 before experiencing a massive downward move back to $8. (~ 20% decrease).
Now could the beta indicator have indicated this in any way? Most certainly NOT.
This is due to the fact that beta is a historical indicator based on data from the past 5 years (or more). Therefore, a severe disadvantage of beta is how it does not take into consideration any short term price movements of a stock.
Case Study 2 – NIO Inc. (NYSE : NIO)
This may not come as a surprise to many due to its intense run up and subsequently run down, but NIO has a an astonishing beta of 2.61! This means that in a bull market, NIO is likely to outperform the market by almost double and likewise in a bear market, we can expect price movements down at twice the intensity.
From June 2020 to Jan 2021, we saw NIO run up by almost 900% whereas in the same time period, we see the S&P increasing by about 25%. There’s no doubt the exponential bull run by NIO was also fueled by other factors, but it comes at no surprise to me given the massive beta NIO currently sits at.
While the pace of the run up for NIO was indeed intense, with its beta at 2.61 we should expect the run down to be just as furious, given how volatile the stock is.
Indeed NIO came crashing with a drop of almost 40% from its highs. (Once again no doubt due to other factors such as chip shortages etc.)
Concluding Thoughts
While the beta may not always predict movements in price, it definitely does its job as an indicator of volatility. Although the case studies used here show instances where the beta indicator has performed well, it is important for investors and traders to understand that no indicator provides 100% certainly.
That said, the beta indicator has allow me to grasp a firmer idea as to the kind of volatility that I can expect for my respective portfolios.
As always, readers should always rely on multiple indicators (including fundamental analysis) before making any trading decisions.