Who would not like to have an exact risk positioning outlined in front before taking any decision? Wish we could impart a precise figure to the associated risk implied in any crucial decisions especially if the situation is extremely volatile as it is in case of stocks.
Stocks have always been a tempting bargain. The opportunity to make fast money has always pushed investors to divulge in activities that have entailed enormous risks and therefore at times have led to major losses. Failure in this arena due to miss appropriation or lack of knowledge has always managed to be the part of every day’s black and white / yellow journal – the newspaper.
In the same context, various measures of analyzing risk profile of the stock market have been deployed by investors. While few have relied on their intuitions, others have employed various statistical means including Beta, which is a measure of stock’s volatility in relation to market.
For calculation purposes, market has been assigned the beta value as 1.0 and any deviation in stocks from the same generates their corresponding value. The figure is positively correlated with the stock movement i. e. if the particular stock swings more than the market the figure increases (beta > 0.1) and if stock swings less; the figure decreases (beta < 0.1). The analyzing factor here is that a higher beta value implies higher risks and higher associated returns, during an up market and a low value implies a lower risk bundled with lower returns. Stocks with a low beta value are considered safe investment options.
Beta: Leads and Shortcomings
Beta can be certainly appropriated as a straight method of analyzing risks inherent in these volatile markets. Being a part of the capital asset pricing model, it is also deployed for calculating the cost of equity. A higher beta implies a higher cost of capital discount rate and therefore lower value of the company’s future cash flow.
However, even this tool is not free of any shortcomings. Beta is evaluated primarily on the earlier price movements; however, they cannot be the sole deciders of future prospects. What if new stocks do not have a substantial price history to calculate reliable figures? In this case beta does not seem to help.
Also there are a host of factors that contribute to information required for assessing risks which are not accounted for by this analyzing tool. For instance, beta does not account for new information and therefore is a little redundant for evaluation purposes.
The rapid fluctuations do not ensure a long-term commitment where Beta is concerned.
A wrap up…
Beta is certainly a useful tool for the analyzing the risk profile of stocks especially to naïve investors who intend to invest only for short-term purposes. The easy to decipher tool is a straightforward approach to this complicated market. However in the long run it is essential to club this measure with various other analysis tools and subsequently work out the associated risks.
Alexander Gordon is a writer for http://www.smallbusinessconsulting.com - The Small Business Consulting Community. Sign-up for the free success steps newsletter and get our booklet valued at $24.95 for free as a special bonus. The newsletter provides daily strategies on starting and significantly growing a business.
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