An Overview

In recent years, investors have put billions of dollars into so-called “smart beta” investing techniques. However, before investing in any strategy, like any other investment, it is essential to grasp its ideas. So, let us investigate the concepts behind the current popularity of smart beta techniques. Stock market indexes track the performance of the stock market as a whole or in different segments. The S&P 500 Index, for example, is a frequently used indicator of the overall performance of the US stock market. As the name implies, this index tracks daily changes in the market capitalization of 500 big US firms.

What is the Beta Value of the Stock?

The word “beta” simply refers to a stock’s susceptibility to general stock market volatility. The beta for the S&P 500 is 1.0. An individual stock’s beta is determined by how it performs in comparison to the beta of the index. A stock with a beta of 1.0 moves in lockstep with the S&P 500. A stock’s beta will be greater than 1.0 if its performance has historically been more volatile than the market.

Alpha Vs. Beta

Another terminology you’ll come across while exploring investing, especially mutual funds, is “Alpha.” In contrast to beta, which measures volatility, alpha assesses a portfolio manager’s ability to exceed a market index. The difference between a portfolio’s actual returns and its projected performance, given its amount of risk as defined by beta, is referred to as alpha.

For example, if a mutual fund tracking large-cap stocks returned 10% in a year while the S&P 500 grew just 5%, the fund’s alpha would be more significant. In contrast, if the fund earned 10% in a year while the S&P 500 gained 15%, it would earn less alpha. The baseline alpha metric is zero, indicating that the investment was performed precisely in accordance with its benchmark index. In general, if you were looking to invest in a mutual fund or any managed investment option, you would look for managers with a more significant alpha. Remember that alpha and beta are both based on previous data. Past performance is no guarantee of future outcomes, as every investment prospectus advises.

Types of Beta in Stock Market

The types of beta values in shares that assist investors in understanding the risk associated with the stocks are as follows.

• Beta Less Than One: When the beta number is less than one, it indicates that they fluctuate at or near the general market level. They are also known as low-beta stocks. It enables investors to earn modest yet consistent profits. These stocks are low-risk investments. Consequently, they are less volatile in the face of market volatility.

• Beta Greater Than One: When the beta coefficient is more significant than one, it indicates that the is more volatile than the general stock market. They are also known as high-beta stocks. It enables investors to benefit significantly. However, such stocks are extremely risky. Consequently, each market decline leads to a sharp drop in stock prices. Small and mid-cap firms are often considered high-beta stocks.

• Beta Is Equivalent To Zero: When the instrument’s beta value equals 0, the financial instrument carries minimal risk. Government bonds, fixed deposits, cash, and other similar assets come under this group. Investors examine these securities for portfolio protection.

• Beta Is Equal To One: When the beta coefficient value is one, the security is associated with the stock market or indexes. Furthermore, these stocks are regarded as reliable and secure. Compared to the benchmark index, they have a comparable influence on share price and returns due to market changes. Large-cap firms have a beta of one since they are the fundamental constituents of benchmark indexes.

Advantages of Beta in the Stock Market

• Demonstrates Previous Performance: A stock’s beta represents a measure of stock price movement in relation to the price movement of the stock market as measured by a predefined benchmark index. This assists prospective investors in determining the projected return on equity on the entire amount invested in such assets.

• Reflects The Associated Unsystematic Risk: The beta value of a stock is one of the essential factors that investors consider before investing. In addition, it assists users in analyzing a company’s unsystematic or market-related risk, demonstrating the extent of interrelation between the two criteria.

What is a Good Beta for a Stock?

As previously mentioned, the beta value of a stock measures its susceptibility to market changes. Therefore, investors may design a portfolio that suits their risk tolerance by knowing a stock’s beta. However, in recent years, a new approach to index investing known as the smart beta has begun to gain favor among investors. Smart beta is an improved indexing method that aims to utilize certain performance variables to exceed a benchmark index. In this regard, smart beta varies significantly from standard passive indexing strategies.

Smart beta methods are also distinct from actively managed mutual funds, in which a fund manager selects specific companies or sectors to outperform a benchmark index. By investing in tailored indexes or ETFs based on one or more specified “factors,” smart beta strategies strive to increase returns, diversify, and decrease risk. They seek to beat, or to be less risky than, standard capitalization-weighted benchmarks while often charging fewer fees than a regular actively managed fund.

Limitations of Beta in the Stock Market

• The Noise Issue: Using a worldwide index, such as the S&P 500, may alleviate the problem of a few companies dominating the index, but it exacerbates the second issue with regression beta estimations. The beta estimate from the regression is noisy, and the emerging beta range is wide.
• The Index Issue: The regression betas are obviously influenced by estimate options such as period, return interval, and index. The beta will vary greatly depending on how the regression is set up and run. When we estimate betas for firms in developing markets. Using the local market index, which is still used by most providers, yields a very acceptable regression.
• The Issue of Firm Change Over Time: Even if a stock does not dominate the index and the regression beta has a low standard error, regression beta estimations have a critical flaw. They are based on past data, and businesses evolve with time. As a result, the regression represents the business’s characteristics on average across the estimated period rather than the firm as it exists now.

Who May Invest in High Beta Stocks?

Stock beta assists investors in determining the risk factor linked with them. Investors with a high-risk tolerance level might choose assets with beta values more significant than one since they can potentially deliver significant profits. However, investors must be aware that high-beta assets are susceptible to stock market swings, which may result in investment losses. Small and mid-cap firms, for example, are high beta equities with significant growth potential. Investing in such firm stocks or bonds might result in huge gains. As a result, investors profit from dividend distributions or capital gains from resale at a later period.

On the other hand, investors with a low-risk tolerance might choose companies with betas smaller than one. These investments generally provide consistent returns. Instruments that are not directly impacted by stock market fluctuations and give fixed returns often have a beta value of less than one. Alternatively, such investors might evaluate equities whose beta value is equivalent to a market with similar volatility. 

For example, large-cap firms often have beta values near one since they are the critical components of market indexes. Even though such assets do not provide significant returns, their consistency and high dividend distributions often result in wealth accumulation. It may also be a smart addition for portfolio diversification since these assets can withstand market downturns, ensuring that stock prices do not fluctuate dramatically.

How to Invest in High Beta Stocks?

Investors seek stocks with a high beta index to outperform the average market return on investment. When the general stock market is bullish, such investors often concentrate on high-beta stocks to maximize possible profits from the higher volatility that such equities are anticipated to display.

However, more significant returns come with more risk since profits and losses may be magnified compared to the broader stock market. As a result, investors prefer to avoid high beta equities during bear markets because they may incur bigger losses than the general stock market.

Wrapping Up

As a result, the beta value of stocks is an essential tool that investors should consider before investing in any stock market instrument. Though not an all-inclusive figure, beta assists investors in analyzing the market risk connected with a certain instrument and its impact on the related returns. Aside from other products, Stockal includes a variety of ETFs to discover Beta in the stock market, such as the S&P 500 High Beta Index.