Beta is related to the risk in holding securities, associated with the possibility that realised returns will be less than the returns expected.
There are two types of risks:
- Unsystematic risks - Risks unique to a firm or industry such as management capability, consumer preferences, labour, etc. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio.
- Systematic risks - Risks associated with economic, political, sociological and other macro-level changes which affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio.
The degree to which stocks / portfolios are affected by systematic risks as compared to the effect on the market as a whole, is different and measured by beta. In other words, systematic risks of various securities differ due to their relationships with the market. The beta factor describes the movement in a stock’s or portfolio's returns in relation to that of the market returns.
Thus, beta is a measure of a stock's or portfolio’s volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A beta of 1 indicates that the security's price will move with the market. A stock that swings more (in either direction) than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns while low-beta stocks pose less risk but also lower returns.
For all practical purposes, market returns are measured by the returns on the index (Nifty, Sectoral index etc.) being a good reflector of the market. If a stock's beta is 1.2, it's theoretically 20% more volatile than the market. If market rises by 2%, the stock will theoretically rise 2.4%.
E.g. If SBI has beta of 1.27 while Punjab National Bank has beta of 0.91, SBI is perceived to be more riskier that PNB or in other words, it will theoretically give higher returns vs PNB if the market (Nifty / Bank Nifty) gains.