Risk Measure and Beta ratio


What is the risk of holding a company’s share? That you would lose money, or earn lesser returns than you expected to. Measures of risk: The basic premise of capital markets and investing is that all investors are risk averse. All investors prefer to minimize risk and maximise returns. So, let’s assume a hypothetical case where you have two securities in your portfolio: HDFC Bank and Dhanlaxmi Bank. The risk levels of both the securities are the same, but the expected returns for HDFC Bank is 12% whereas for Dhanlaxmi Bank is 8%. Which one would you invest in? Naturally, in HDFC Bank. Now, let’s assume, the risk of investing in HDFC is slightly higher than before, would you be satisfied with the same amount of returns as before – 12%, or would you expected to be rewarded higher for assuming more risk? Yes, any investor would expect a higher return for taking on greater risk. But, how is this risk measured? And is it comparable with another firm from another industry? The total risk measure comprises systematic risk and unsystematic risk. Standard deviation measures the total risk.
Total risk = Systematic risk + unsystematic risk
1. Unsystematic risk – the kind of risk that is specific to a company or a small set of stocks. Regulations impacting a particular industry like mining ban in Karnataka, or the 2G scam affecting telecom industry are examples of unsystematic risk. Unsystematic risk can be reduced by diversifying one’s portfolio. Workers’ strike at Maruti’s plant in Manesar in Haryana last year is a type of unsystematic risk. The event lead to a decline in quarterly sales and not able to fulfill orders. Reducing exposure or not investing in Maurti in one’s portfolio, and instead having Mahindra & Mahindra or some other defensive stock like FMCG, is an example of reducing unsystematic risk.
2. Systematic risk (also known as market risk – measured by beta) – The risk that a portfolio is exposed to after diversification is called systematic risk. This risk arises from factors beyond one’s control such as macroeconomic factors or policies of a government, or political events. Systematic risk affects the entire market irrespective of the industry. A good example is the effect of Greece’s debt default on Indian stocks, or global stocks for that matter. Systematic risk is measured by beta.
What is beta? Beta is a measure of systematic risk, a risk that cannot be avoided by diversifying one’s portfolio. In simple terms, it measures the volatility of a stock’s returns in comparison to the market. Beta is used to calculate a stock’s expected return in the widely followed capital asset pricing model (CAPM). E(R) = RFR + β*ERP where E(R) = expected returns of a stock RFR = Risk free rate (for example, government/sovereign bonds) β – beta ERP – expected risk premium calculated as expected returns on market – risk free rate For ease, the beta for Indian stocks is measured relative to a index such as Sensex or Nifty.
Why is beta measure important? Beta measure is significant because it tells you how a stock’s returns are commensurate with the market especially in a highly volatile period such as the period after August 2011, . High beta stocks fall rapidly during market decline and gain more than the market during a rally. High risk, high returns is the premise.
Let’s dig deeper to see how it’s calculated – a lot of fancy stuff, but not boring, I promise! β = covariance of a stock’s returns relative to market returns/ variance of market Covariance is a statistical measure that defines the movement of two variables. It can take any value from -ve inifinity to +ve infinity; the number by itself doesn’t convey anything.
What does a beta value of 1.3 or 0.8 mean? A stock’s beta of 1.3 implies the stock is 30% more volatile than the market or index it is compared against. Commodity and banking stocks usually have a higher beta whereas defensive stocks have a beta lesser than 1. A beta of 0.8 indicates the stock is 20% lesser volatile than the market.