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Beta Analyzing The Risk Profile Of Stocks

Aug 17, 2007
Who would not like to possess an exact measurement of risk outlined in front of them before taking any decision? Everyone involved with risky ventures wishes they could impart a precise figure to the associated risk. This risk is implied in any crucial decisions especially in the case of stocks.

Stocks are a tempting bargain. The opportunity to make fast money pushes investors to divulge in activities that entail enormous risks and, at times, lead to major losses. Failure in this arena, due to misappropriation or lack of knowledge always manages to be a part of the day's newspaper coverage.

In the same context, investors deploy various measures of analyzing the risk profile of the stock market. While a few rely on their intuition, others employ various statistical means including Beta, which is a measure of stock's volatility, in relation to the market.

For calculation purposes, the investor assigns the market a beta value of 1.0 and any deviation of the stocks from the market generates a corresponding value. The figure is positively correlated with the stock movement, if the particular stock swings more than the market the figure increases and if the stock swings less, the figure decreases. During an up market a higher beta value implies higher risks and higher associated returns and a low value implies a lower risk bundled with lower returns. Stocks with a low beta value are considered safe investment options.

Leads And Shortcomings Of The Beta Value System
Beta is a straight method of analyzing the risks inherent in these volatile markets. As a part of the capital asset pricing model, investors also deploy it for calculating the cost of equity. A higher beta implies a higher cost for the capital discount rate and therefore a lower value for the company's future cash flow.

This tool is not free of shortcomings. Investors evaluate Beta primarily on the earlier price movements. However, the earlier price movements 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 the Beta system does not help.

There are a host of other factors that contribute to the information required for assessing risks, which are not accounted for by this analyzing tool. For instance, Beta does not account for new information and is a little redundant for evaluation purposes. The rapid fluctuations do not ensure a long-term commitment where Beta is concerned.

In Conclusion
Beta is certainly a useful tool for analyzing the risk profile of stocks, especially for naive investors, who intend to invest only for short-term purposes. This easy to decipher tool is a straightforward approach to a complicated market. However, in the long run, it is essential to join this measure with various other analysis tools and subsequently work out the associated risks.
About the Author
David Gass is President of Business Credit Services, Inc. His company publishes a free weekly e-newsletter on Small Business Consulting at their web site http://www.smallbusinessconsulting.com
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