How does beta help to assess the risk of a stock?

The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period

While the concept of risk is rather challenging to factor in stock analysis and valuation, one of the most popular and easy measures of risk is beta. This is a statistical measure that compares the volatility of returns on a specific stock to those of the overall stock market or a relevant broad market index.  

The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period. Often referred to as financial elasticity, beta expresses the trade-off between minimising risk and maximising return.  

Theoretically, the beta value of the overall stock market or a benchmark index is considered to be 1. A stock with a beta of 1 indicates that stock returns fluctuate in proportion with the markets while moving in the same direction. Typically, Large-Cap stocks tend to have a beta of 1 as they are the constituents of frontline benchmark indices.  

A beta greater than 1 indicates that the stock’s price will be more volatile in comparison to the market. For example, if a stock’s beta is 1.2, it is theoretically 20 per cent more volatile than the market. Meanwhile, stocks that move in the same direction as the markets but are proportionately less volatile have a beta of less than 1 but more than 0.  

Investors should also note that there are certain stocks which have beta of less than 0 and in that case the direction of the stock is completely opposite to that of the financial markets. A negative beta indicates an inverse relation between the stock and the overall market.