Beta is a measure of a stock's or a fund's volatility in relation to the overall market. A beta of 1 implies that the asset’s price moves with the market. A beta greater than 1 indicates higher volatility than the market and a beta less than 1 means less volatility. Investors use beta to understand a stock's risk in comparison to market risk and to build a diversified portfolio.
In portfolio management, beta is crucial for the concept of the Capital Asset Pricing Model (CAPM), which is used to calculate the expected return of an asset based on its beta and expected market returns. A high-beta stock is expected to give higher returns in a rising market but suffer more in declining markets. Conversely, a low-beta stock might not climb as much in good markets but could offer some protection in down markets.
While beta is a valuable tool for assessing market risk, it does not account for specific risks related to an individual stock or sector. Also, beta is based on historical data, which means it may not always predict future market behaviours accurately. Investors should use beta as one of several tools in assessing investments, considering other factors like company fundamentals and economic indicators.
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