What is the beta coefficient in stock market trading?

Every financial market in the world has predictable risk and return, and this risk and return can vary depending on the situation.

The main point is the combination of risk and return in the capital market . Risk and return on the stock market are each part of the investment process, but the main goal of market participants is to create balance in these two indicators.

If you as an investor have the ability to balance risk and return, you can achieve significant success in the capital market.

What is the Beta Coefficient in stock market trading?

This coefficient in transactions generally determines the risk and return of one share or a portfolio of several shares in the general conditions of the capital market. Therefore, the correct calculation of this coefficient and its use in transactions is very important. Calculating the beta coefficient in trading can help the investor in recognizing the impact of capital market changes on a share.

If we want to define it more simply, we can say that in general, the beta coefficient determines the amount of risk that a person incurs in his investment in relation to the whole market.

 But as mentioned, the beta coefficient is a set of risk and return, and before examining the method of calculating it, we must first examine the risk and return.

 

Beta coefficient

What is capital market risk and on what basis?

In general, if we want a simple and clear definition of risk, we can say that the more the return on investment on one or more shares varies, the higher the risk. Investment risk is often divided into two categories. Systematic risk (unavoidable) and non-systematic risk (avoidable); In the following, we will examine each of them in full.

What is non-systematic risk?

Non-systemic risk, or in other words, specific risk, is one of the types of investment risks and arises from the internal conditions of the company in which you invest.

For example, if you have bought the shares of Iran Khodro Company and the employees of this company go on strike for 3 days for any reason, you, as a shareholder of this group, are in a situation of non-systematic risk and this non-systematic risk in any case. Affects the company’s stock.

There is an important point about unsystematic risk. As an investor, you can minimize and somehow avoid unsystematic risk by creating more diversity in your portfolio.

What is systematic (unavoidable) risk?

Systematic risk or in other words unavoidable risk is related to the whole market. In the language of market participants, this risk is also called market risk or irreversible risk. This type of risk affects the market as a whole. This risk is almost always inevitable and can be said to be unpredictable. Since this risk is related to the total investment in the market, it can not be eliminated by non-systematic risk method.

There are several reasons for creating systematic risk, such as changes in the country, economic changes, political changes, and so on. Due to the high importance of systematic risk in investing and the lack of a clear way to avoid this risk, an indicator was introduced to measure it, which is known as beta.

Why is the beta coefficient calculated?

If you ask yourself why should this coefficient be calculated? In response, it can be said that the beta coefficient is calculated to know the systematic risk of each share and investment. In order to calculate this characteristic in investment, stock price index is used. In the following, we will talk in detail about the method of calculating the beta index.

Beta coefficient

Training on calculating the beta coefficient in capital market transactions

In order to calculate the beta index, which is not easily possible, the following steps must be followed. The following factors affect the calculation of this index:

1. Expected return on investor assets:

This factor indicates the amount of return on investment that is expected through existing forecasts and analyzes. Expected stock returns are obtained from the set of returns due to the increase of the company’s capital, increase of the stock price and..

 

2. Risk-free return on capital

This factor determines the lowest rate of return expected by the investor without accepting and taking any risk. In general, this return is the same as the bank interest rate.

 

3. Market return

But in the third case, in the Iranian capital market, basically the total index of stock exchanges and securities in calculating the beta coefficient per share, market return is considered.

Finally, the formula for calculating the beta coefficient is as follows:

  • Step 1: The risk-free return is deducted from the expected return on the asset.
  • Step 2: Risk-free returns are deducted from market returns.
  • Final step: The result obtained in the first step is divided by the result obtained in the second step.

In other words, if we want to observe the formula objectively, this formula will be as follows, which we will examine in the following example:

Risk-free return – Market return / Risk-free return – Expected return on assets

Example of calculating the beta index in one-share transactions

Suppose you want to calculate the beta index for the shares of Iran Khodro Company. To calculate risk-free returns, we consider the bank interest rate.

 

Considering the 20% bank interest rate for risk-free return, the expected return on Iran-Khodro shares is considered 50% based on the information received about this share, and finally the expected return on the stock index is 40%. In this case, and based on the method used to calculate the beta index, we can say:

Risk-free return – Market return / Risk-free return – Expected return on assets

1.5 = (0.2 – 0.4) / (0.2 – 0.5)

In the above calculation, the beta coefficient, for example, shows the number 1.5. But what does this number mean and what is its use and result? In the next section, we analyze this number, and ultimately the goal is to arrive at a clear and definite interpretation of the conditions of a stock that we intend to enter and operate in.

 

Beta coefficient

What does the beta coefficient mean for the stock?

This number can create 5 states in total, in the following we will examine the mentioned states one by one:

  • The beta coefficient is greater than 1

If the beta coefficient is more than 1, it indicates that the share changes are in the direction of market changes. Beta coefficient greater than 1 means that if the total stock index falls or rises by 1%, the stock will fall by n or equal to the beta coefficient. In this case, the systematic risk is high. If the beta coefficient is more than 1, this type of share is suitable for the bull market and it is called offensive stock.

  • The beta coefficient is equal to 1

In the other case, if the beta coefficient is equal to 1, the share changes will be in the direction of the market and the amount of systematic risk will be equal to the stock index. In this case, if the stock index has a one percent decline or growth, the share will fall or rise as much. If the beta coefficient is equal to the number one, the stock is suitable for the uptrend of the market, just like before.

  • Beta coefficient is between zero and 1

In this case, the share changes are also market-oriented and the systematic share risk is not high. Under these conditions, as the beta coefficient is higher than one, if the index has a percentage increase or decrease, the stock increases or decreases by n times its beta coefficient. For example, if the beta coefficient is 0.5, if the stock index grows by 1%, it will grow by 0.5%.

  • The share beta coefficient should be between 0 and -1

Under these circumstances, share changes are the opposite of market changes and systematic risk will be low. For the beta coefficient between 0 and -1, if the total index has a decrease or increase of 1%, the share of the beta coefficient will inversely increase or decrease. For a beta of less than one, the right market stocks are downward and are also called defensive stocks.

  • Beta factor is less than -1

If the numerical beta coefficient is less than -1, stock changes are in the opposite direction of market movement and systematic risk increases. In this case, if the stock index has increased or decreased by one percent, the stock will decrease or increase by the beta coefficient. Completely upside down.

Conclusion

Finally, according to the said formula and also the interpretations that are obtained from the final number of this formula, you can check the entry conditions of each share and reduce the systematic risk in the capital market and for your capital, because in general The beta calculation is used only to determine the amount of systematic risk in the stock market.