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Smart Investing: Beta Version

Say the word beta to a tech professional and an investor and each will interpret it differently. The tech professional will instinctively think of the software implication.

Say the word beta to a tech professional and an investor and each will interpret it differently. The tech professional will instinctively think of the software implication. Beta, as most of us would know, is the last leg of the software testing phase. It is not the final version of a product or website but close enough to show in public and work the bugs out. Now ask the finance professional or investor and he will immediately think of volatility. Simply put, beta is the measure of a fund's (or stock's) volatility relative to the market or the benchmark.

Assume a fund is benchmarked against the Sensex. A beta of more than 1 implies that the fund is more volatile than the market. A beta of less than 1 implies lesser volatility.

Let's say that there are two funds, one with a beta of 2.5 and the other, 0.4. If the market rises 1 per cent, the fund with a beta of 2.5 will rise by around 2.5 per cent and the fund with a beta of 0.4, will rise by 0.4 per cent. The similar relationship will take place in a falling market. So beta is a quantitative measure of the volatility of a fund or stock relative to the market.

Beta & You
Essentially, beta expresses the fundamental tradeoff between minimising risk and maximising return. A fund with a beta of 1 will historically move in the same direction of the market. A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile. So while you can expect a high return from a fund that has a beta of 2, you will have to expect it to drop much more when the market falls.

The effectiveness of the beta depends on the index used to calculate it. It can happen that the index bears no correlation with the movements in the fund. For example, if beta is calculated for a large-cap fund against a mid-cap index, the resulting value will have no meaning. This is because the fund will not move in tandem with the index. Being fairly straightforward, beta offers a lucid, quantifiable and convenient measure which makes it easy to work with.However, it has its limitations too. Beta is a historic tool that does not incorporate new information. For instance, a company may venture into a new business and assume a high debt level. Yet, the beta will not capture this new risk taken on. Since beta relies on past movements, it cannot be used for new stocks that have insufficient price history to establish a reliable beta.

Finally, beta is just an indication. It relies on past price movements which are not foolproof predictors of future behaviour.