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Beta: Measuring a Stock's VolatilityIt goes without saying that investing in growth stocks can be “risky” or “volatile,” but how does one measure these terms? Such a measure would immensely help an investor quantify his risk to determine whether or not he could stomach the swings of a particular growth stock. Luckily for you, there is such a tool, and it is known as “beta.” It will allow you to sleep at night and still own aggressive growth stocks.
Beta: Defined
Beta measures a stock's volatility, the degree to which its price fluctuates in relation to the S&P 500. In other words, it gives a sense of the stock's market risk compared to the greater market. The key word here is “compared.” Beta is used also to compare a stock's market risk to that of other stocks. Analysts use the Greek letter 'ß' to represent beta.
A beta of 1 means that the stock’s price tends to move with the broader market. A beta greater than 1 indicates that the security's price tends to be more volatile than the market, and a beta less than 1 means it tends to be less volatile than the market. Many utility stocks have a beta of less than 1, and, conversely, many aggressive growth stocks have a beta greater than 1. Here is a basic rundown of what the various beta ranges mean:
Beta of 0 - Cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (with the assumption of no inflation).
Beta between 0 and 1 - Companies with volatilities lower than the market have a beta of less than 1 (but more than 0). As we mentioned earlier, many utilities fall in this range.
Beta of 1 - A beta of 1 represents the volatility of the given index used to represent the overall market, against which other stocks and their betas are measured. The S&P 500 is such an index. If a stock has a beta of one, it will move the same amount and direction as the index. So, an index fund that mirrors the S&P 500 will have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is greater than the broad-based index. Again, as we mentioned above, many technology companies on the Nasdaq have a beta higher than 1.
Growth Stocks and Beta
As an aggressive growth investor, you are probably willing to stomach more risk than your deep value or income-oriented peers. However, accurately quantifying that risk/reward scenario will improve your returns and increase your peace of mind. For example, if you want to shoot for the stars and are playing with money you can afford to lose, you should buy higher beta stocks in order to get the most bang for your buck. These stocks would have betas of 2.5 and above. This means if the S&P 500 increases 1%, your stock would rise 2.5%.
If you want growth exposure, but get motion sickness with extreme volatility, pick a stock with a beta in the 1.5 range. It would still gain 50% more than the market, yet wouldn’t destroy your portfolio in the event of a downturn. This leads me to an important point.
Know Thy Market’s Direction
Obviously, it is vital to have a general feeling for how the overall market is doing, since that is the basis for comparison with beta. If the market is trending upward with strong earnings estimate revisions, then it may behoove you to buy stocks with higher betas, as they would outperform. Conversely, avoid higher beta stocks in a weak market with decreasing estimate revisions. Beta is a powerful and often over-looked tool for investors. Buying high-beta stocks in a down market can cause severe heart palpitations. The medicine for that is, you guessed it, beta blockers.
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