Standard Deviation, Beta and Correlation — For Dummies!
*For educational purposes only. This doesn't constitute financial advice.
Casual Read
Standard Deviation: A higher standard deviation indicates greater volatility, reflecting the uncertainty and risk associated with the stock.
Ex. Consider Stock A, which has an average return of 8% with a standard deviation of 12%. This means the stock’s returns typically deviate by 12% from its average.
Beta: Beta helps investors gauge a stock’s sensitivity to market movements.
Ex.If Stock B has a Beta of 1.2, it tends to move 20% more than the overall market. If the market goes up by 10%, Stock B might go up by 12%. Conversely, if the market drops by 10%, Stock B could fall by 12%.
Correlation: Correlation measures the strength of the relationship between two stocks.
Ex. Let’s say Stocks C and D have a correlation of 0.7. If Stock C rises, there’s a 70% chance that Stock D will also rise. Conversely, if Stock C falls, there’s a 70% chance that Stock D will also fall.
Let’s compare them in everyday terms:
Volatility (Standard Deviation):
Think of Standard Deviation as the “roller-coaster ride” of a stock. A higher standard deviation means the stock’s performance is like a more unpredictable roller coaster, with steeper ups and downs.
Sensitivity (Beta) is like adjusting the volume on your TV. A Beta greater than 1 amplifies the market’s movements, like turning up the volume. A Beta less than 1 tones down the market impact, like lowering the volume. A Beta of 1 means it moves in sync with the market.
Relationship (Correlation): Correlation is like observing friends playing a game. A correlation of 1 means they always play together (positive correlation). A correlation of -1 means when one friend plays, the other never does (negative correlation). A correlation of 0 means their game preferences have no influence on each other (no correlation).
In essence
- Standard Deviation measures the volatility or unpredictability
- Beta gauges the amplification of market moves
- Correlation assesses the degree of coordination between two stocks.
Deep Dive: Here are generic illustrations of the above 3 concepts — from the Indian stock market. Please note that the actual values for stocks vary. Investors to make more informed investment decisions
BETA Examples
- Reliance Industries (Beta > 1): Given its prominence and influence on the market, Reliance Industries might have a Beta greater than 1, signifying that its stock tends to be more volatile than the overall market.
2. HDFC Bank (Beta < 1): As a stable and well-established banking stock, HDFC Bank may have a Beta less than 1, indicating that its price movements are generally less volatile compared to the overall market.
3. ITC Limited (Beta ≈ 0): ITC, being in the FMCG sector, might exhibit a Beta close to 0, suggesting relatively lower sensitivity to market fluctuations due to the defensive nature of the industry.
4. Maruti Suzuki (Beta > 1): Maruti Suzuki, being in the automotive sector, could have a Beta greater than 1, implying that its stock tends to experience larger price swings compared to the market.
5. Infosys (Beta ≈ 1): Infosys, as a major IT company, may have a Beta close to 1, indicating a correlation with the market but with similar volatility. This implies that Infosys’ stock movements align closely with the overall market.
Standard Deviation Examples
- Reliance Industries (Example): Suppose the monthly returns of Reliance Industries exhibit a standard deviation of 15%. This implies that, on average, the monthly returns of Reliance Industries deviate by 15% from its mean return. Higher standard deviation suggests higher volatility.
- HDFC Bank (Example): If HDFC Bank has a lower standard deviation of 8%, it indicates relatively lower volatility in its monthly returns compared to a stock with a higher standard deviation.
- ITC Limited (Example): Imagine ITC Limited, known for its stability, has a standard deviation of 10%. This suggests that its monthly returns fluctuate less compared to a more volatile stock.
- Infosys (Example): If Infosys, a technology stock, has a standard deviation of 20%, it implies higher volatility in its monthly returns, reflecting the nature of the technology sector.
- Nifty 50 Index (Example): Consider the Nifty 50 Index with a standard deviation of 12%. This reflects the average volatility of the 50 stocks in the index. Investors might use this information to gauge the overall market risk.
Correlation Examples
- Positive Correlation: (a) HDFC Bank and ICICI Bank: These two major Indian banks often show a positive correlation. When the banking sector performs well, both stocks tend to rise together due to shared economic factors.
(b) Tata Consultancy Services (TCS) and Infosys: As leading IT companies in India, TCS and Infosys typically exhibit positive correlation. Changes in the overall demand for IT services often impact both stocks similarly.
2. Negative Correlation: (a) Oil Marketing Companies (OMCs) and Airlines (e.g., IndiGo): OMCs and Airlines may have a negative correlation in India. When oil prices rise, OMCs might benefit, but airlines may face increased operational costs, creating a negative correlation.
(b) IT Stocks and Gold Mining Companies: Indian IT stocks and gold mining companies might display negative correlation. Economic uncertainties leading to a rise in gold prices may negatively affect the technology sector.
3. No Correlation (Zero Correlation): (a) ITC Limited and Axis Bank: These two stocks may show little to no correlation as they belong to different sectors — ITC in FMCG and Axis Bank in banking. Their performances are influenced by distinct industry factors.
(b) Cipla and Larsen & Toubro (L&T): The pharmaceutical and infrastructure sectors represented by Cipla and L&T, respectively, might exhibit low correlation due to differences in market dynamics.
4. Strong Correlation: (a) Nifty IT Index and Nifty Pharma Index: These indices, representing IT and pharmaceutical sectors, may demonstrate a strong correlation during certain market conditions, as both sectors can be influenced by global economic trends.
(b) State Bank of India (SBI) and Bank Nifty Index: SBI’s stock and the Bank Nifty Index could have a strong correlation as SBI is a significant component of the banking index.
5. Weak Correlation: (a) Titan Company and Indian Oil Corporation (IOC): The jewellery retail sector represented by Titan may have a weak correlation with IOC, which operates in the oil and gas industry.
(b) Hindustan Unilever (HUL) and Steel Authority of India Limited (SAIL): FMCG giant HUL and steel manufacturer SAIL might exhibit weak correlation due to differences in their business models and market dynamics.
Understanding these concepts helps investors manage risks and make informed decisions in the stock market.
You can refer to these NSE Factsheets for Sector wise values.
Sample report is provided at this link
✍🏻✍🏻I am NOT a SEBI registered advisor or a financial adviser. This blog is intended to provide educational information only and does not attempt to give you advice that relates to your specific circumstances. You should discuss your specific requirements and situation with a qualified financial adviser.
