Risk is a part of the investment process and we all need to be aware of the risks of investing in stock markets. We can start with having a measure of these risks with the help of beta.

With the help of beta we can approximately tell how much a particular stock will move if we know how much the whole stock market is going to move. Thus, beta tells us what the volatility is in a particular stock with respect to movements in the stock market. Beta is also referred to as financial elasticity or correlated relative volatility.

Definition - "The Beta Coefficient in terms of finance and investing is a measure of the systematic risk of a stock or portfolio. It quantifies relative volatility in relation to the overall market, which is defined as having a beta of 1".

Calculation - Beta is calculated on historical basis with the help of historical returns on a particular stock and historical returns on the stock market. The whole method consists of finding covariance between the market returns and stock returns and dividing it by the variance of market returns. It is calculated with the help of the following formula: 

Beta Risk = Cov (r_a,r_p)/Cov (r_p)
Where 
r_a measures the rate of return of the stock
r_p measures the rate of return of the portfolio
Cov(r_a,r_p) is the covariance between the rates of return

Interpretation - By definition, the market itself has an underlying beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market (i.e. more volatile) over time has a beta whose absolute value is above 1.0. If a stock moves less than the market, the absolute value of the stock's beta is less than 1.0.More specifically, a stock that has a beta of 2 follows the market in an overall decline or growth, but does so by a factor of 2 meaning when the market has an overall decline of 3% a stock with a beta of 2 will fall 6%. Higher beta stocks mean greater volatility and are therefore considered to be riskier, but are in turn supposed to provide a potential for higher returns, low-beta stocks pose less risk but also lower returns. In the same way a stock's beta shows its relation to market shifts, it also is used as an indicator for required returns on investment (ROI). If the market with a beta of 1 has an expected return increase of 8%, a stock with a beta of 1.5 should increase return by 12%. Also, if the beta of a stock is less than 1, such as 0.5, the stock will move at a rate of half of the market. For example, if the market increases by 10% the stock itself will increase only 5% and vice versa.

Uses and some interesting facts with beta-

• Beta are calculated on historical prices thus it does not provide the exact picture for future and are backward looking
• Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile stocks.
• Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds. However, simply because a beta is zero does NOT mean that it is risk free. A beta can be zero simply because the correlation between that item and the market is zero. An example would be betting on horse racing. The correlation with the market will be zero, but it is certainly not a risk free endeavor.
• A negative beta simply means that the stock is inversely correlated with the market. Many precious metals and precious-metal-related stocks are beta-negative as their value tends to increase when the general market is down and vice versa.
• FMCG, Pharmaceutical stocks are thought to be less affected by cycles and usually have lower beta. Reality and infrastructure stocks have higher beta and are more risky.

Beta is not without its own criticisms:

• Past price fluctuations cannot completely describe the risk in a security as past fluctuation cannot give exact picture of future.
• Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.

The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore beta is not the perfect measure of risks but it helps you to analyze in a broad range how much your stock returns can deviate and it is also an integral part capital asset pricing theory which is used to calculate required returns on a stock.

References:
1) Investopedia: http://www.investopedia.com

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