Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment tips and stock market advice. Each Investor Toolkit update gives you a fundamental piece of investment advice, and shows you how you can put it into practice right away.
Today’s tip: “Beta ratings will help you measure a stock’s volatility, but they can’t give you any real indication about the company’s long-term prospects for safety and growth.”
Beta ratings are a measure of stock-market volatility. Stocks with a beta of 1.0 have exactly the same degree of volatility as the market they trade in, based on a comparison of fluctuations in the stock and the market index over a period of time, usually five years.
If a stock market investment’s beta is below 1.0, the stock is less volatile than the market. High-beta stocks above 1.0 are generally more volatile than the market. (If a stock has a negative beta, it has an inverse relationship with the market; it tends to fall when the market goes up, and vice versa.)
By following our three-part advice, you naturally diversify into high- and low—beta stock market investments
In a rising market, high-beta stocks tend to jump ahead of the market indexes. However, when the market declines sharply, high-beta stocks can fall more quickly than the market, and be slower to recover. Low-beta stocks may not move up as quickly as the market indexes, but they’re unlikely to fall as far during market declines.
In managing the portfolios of clients of our Successful Investor Wealth Management service, we employ our three-part investment strategy: invest mainly in well-established, dividend-paying companies; spread your investments across the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); and avoid stocks in the broker/public-relations limelight.
By doing this, we naturally diversify into high- and low-beta investments. That adds the potential for strong gains when the market is rising, but also adds an element of stability that helps protect your portfolio when the market declines.
That’s in contrast to market advisors and portfolio managers who take on a lot of risk by loading up on high-beta stocks. These managers can show bursts of high performance when the market is rising. However, when the market declines sharply, these portfolio managers can lose far more than the market, and be far slower to recover—if they recover at all.
For instance, many portfolio managers who focused on high-beta stocks fell much further than the market in the second half of 2008, when the TSX dropped more than 50%. Our selections, on the other hand, fell a lot less than the overall market, and have rebounded much faster.
Well-established companies are the key to earning consistent returns—with greater safety
It’s hard if not impossible to predict when the market will jump. It’s even harder to predict when a rising market will reverse course and plunge. This simple fact of investment life causes an extraordinary amount of loss and investor bewilderment. That’s because it’s all too easy to give yourself credit for a gain that you owe to buying a high-beta stock when the market is rising, or just before the market takes off.
If you mistakenly give yourself credit for a gain like this, you may then go on to fill your portfolio with more of the same kind of stock. That can keep on paying off for a time. But inevitably the market quits soaring and stumbles. When that happens, the worst stocks to hold are the high-beta variety. When the market is falling, they tend to fall even faster.
If stocks like these make up a big part of your portfolio, even a mild market downturn can leave you with horrendous losses.
Keep beta ratings in perspective
All in all, a stock’s beta rating makes a broad statement about its history of volatility. Unfortunately, it tells you nothing about its inherent safety or future prospects. For that, we look to the key factors we analyze in awarding one of our six Successful Investor ratings (Highest Quality, Above Average, Average, Extra Risk, Speculative and Start-up).
COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members
Beta ratings are of special interest to some technical market analysts (analysts who base their advice on past trading history and patterns). Do you use technical analysis to help you buy or sell stocks? Is there a particular type of technical analysis you find especially revealing? What does it tell you about a stock?
Note: This article was initially published on July 23, 2010.
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