We sometimes hear of a commonly used financial term called “Beta”. But what is it?
Beta (β) is a measure of the volatility of a security or portfolio or an individual Mutual fund compared to the market as whole. Beta describes the relationship between systematic risk and expected returns on assets.
Let me explain….
When making an investment, it is necessary to check the fund returns but that alone is not a sufficient condition. Evaluating other parameters like “beta” helps in making better investment decisions in keeping with one’s risk profile.
You can think of beta as the tendency of a security’s returns to respond to swings in the market.
If a mutual fund has a beta of 1.0, it indicates that its price activity is strongly correlated with the market benchmark. A fund with a beta of 1.0 has systematic risk. However, the beta calculation can’t detect any unsystematic risk. Adding a stock to a fund with a beta of 1.0 doesn’t add any risk to the fund, but it also doesn’t increase the likelihood that the portfolio will provide an excess return.
A beta value that is less than 1.0 means that the fund is theoretically less volatile than the market benchmark. Including stock having beta less than 1.0 in a fund makes it less risky than the same fund without the stock.
A beta that is greater than 1.0 indicates that the fund price is theoretically more volatile than the market benchmark. For example, if a fund’s beta is 1.3, it is assumed to be 30% more volatile than the market benchmark. Small cap stocks tend to have higher beta’s than the market benchmark. This indicates that adding the stock to a fund will increase the fund’s risk, but may also increase its expected return.
If a scheme outperformed its benchmark you should try to understand, whether the beta of the scheme was high or the fund manager was able to deliver superior risk adjusted returns.
Let’s demonstrate this with an example. Say there’s a housewife Suman.
Her son is a complete brat. Perhaps he is the naughtiest boy not only in the building where they live, but also in his boarding school where he stays. Now suppose, Suman’s neighbour Seema has to attend to an emergency. Even Seema’s son is quite a brat and therefore most families in the neighborhood refuse to baby sit him. However, Suman willingly agrees because her own son is much naughtier than Seema’s son. So as compared to managing her own son, she finds it extremely easy to look after Seema’s son. This example shows that certain decisions are taken by using comparison as a tool.
A fund with a low beta will better protect investors during downturns, but they will miss out on some gains during bull markets.
Ultimately, an investor is using beta to try to gauge how much risk a stock is adding to a fund. While a stock that deviates very little from the market doesn’t add a lot of risk to a fund, it also doesn’t increase the potential for greater returns.
Hence, while taking an investment decision, it becomes important to understand the expected volatility of your fund with respect to the benchmark and not just the performance.
