Stock Beta Ratings Measure Stock Market Volatility

What is stock Beta?

Stock beta ratings are a commonly used measure of stock-market volatility. To calculate a stock beta, a market index like the S&P/TSX Composite Index is assigned a beta of 1.0.

How is Beta calculated?

Beta is calculated using linear regression analysis by comparing a stock’s price movements to a benchmark index (usually the S&P 500) over a specific period, typically using the formula: Beta = Covariance (Stock Returns, Market Returns) ÷ Variance (Market Returns), where a beta of 1.0 means the stock moves in line with the market, above 1.0 indicates higher volatility than the market, and below 1.0 suggests lower volatility.

If a stock has a beta of 1.0, it means the market and the stock move up or down together, at the same rate. That is, a 10% up or down move in the stock market index should theoretically result in a 10% up or down move in the stock. A beta of 2.0 implies the stock will tend to move twice as much as the market. That is, if the market moves up 10%, the stock should move up 20%. A beta of 0.5 indicates the stock will move one-half as much as the market, either up or down.

What does a negative Beta mean?

A negative beta means the stock tends to move in the opposite direction of the market—when the market goes up, the stock typically goes down, and vice versa—which is rare but can occur with certain defensive assets like gold stocks, some utility companies during specific periods, or inverse ETFs that are specifically designed to move opposite to their underlying index.

What are the limitations of Beta?

Beta has several key limitations: it’s based on historical data which may not predict future volatility, it assumes a linear relationship between stock and market movements that may not always exist, it only measures systematic risk (market-related) while ignoring company-specific risks, it can be distorted by short-term market events or periods of extreme volatility, and it may not accurately reflect a stock’s risk profile during different market conditions or after significant company changes like mergers or business model shifts.

A stock beta can mislead you in other ways. Gold stocks have had an average beta of 0.42 when you use the S&P 500 Index as their benchmark. Such a low stock beta indicates gold stocks are safe investments, like utilities. But they are not, of course, and that’s because their performance and returns have relatively little to do with the performance and returns of the S&P 500 Index. They rise and fall with gold prices.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be automatically calculated by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much, if anything, about its prospects or investment appeal.

To assess a company’s suitability for your portfolio, you are better off using more reliable measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.

Here’s our three-part portfolio building philosophy: invest mainly in well-established, dividend-paying companies; spread your stock market investments across most if not all of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); and avoid stocks in the broker/media limelight.

This balanced strategy contrasts with that of advisors and portfolio managers who aim to load up on high beta shares. Of course they can show bursts of high performance when the market is rising. But 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.

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Stock market research: Don’t be led into a trap by high stock beta shares

We’ve always found betas to be of limited use if any. They provide a general idea of what to expect from a stock, but you should already have that from looking at the stock’s fundamentals. The notion is laughable that you can buy low-beta stocks when the market is going to be weak, and high-beta stocks when it is going to be strong. After all, if you knew when the market was going to be strong or weak, you wouldn’t need to waste time with betas.

While it’s easy to beat the market when the market is soaring, it’s hard if not impossible to predict when the market will start to soar. It’s even harder to predict when a soaring 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 in a soaring market, 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.

Here are 2 keys to picking winning growth stocks—and avoiding the ones that can kill your profits:

1. Know the difference between momentum stocks and growth stocks: Momentum stocks and high stock beta ratings go hand in hand, but it’s all too easy to confuse growth stocks with momentum stocks. Like growth stocks, momentum stocks often move up faster than the market averages. But unlike growth-stock investors, momentum investors aim to profit from short-term trades. Momentum investors are particularly keen on the so-called “positive earnings surprise.” That’s when a company outdoes brokers’ earnings estimates. Momentum investors see a “negative earnings surprise” (or lower-than-expected earnings) as a sell signal. They use a number of formulas to make buy and sell decisions, but all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy. The trouble is that when the stock’s rise falters, momentum investors also try to get out as a group, but there are never enough buyers. That leads to violent fluctuations in the stock’s price.
2. Value stocks can lower your portfolio’s volatility: Most successful investors hold some growth stocks and some value stocks at any given time, depending on where they see the best opportunities. Value stocks are stocks trading lower than their fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many technology stocks, such as Intel, symbol INTC on Nasdaq (a stock we analyze in our Wall Street Stock Forecaster newsletter), started out as growth picks, but have started to transition into value stocks. Growth stocks and value stocks can make a winning combination. A growth stock can be a top performer when the company is growing. However, a single quarter of bad earnings can send it into a deep, but often temporary, slide. Value stocks can test your patience by moving sluggishly for months, if not years. But they can make up for it by rising sharply when investors discover their true value.

All in all, knowing the stock 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 rely on the key factors that yield our TSI Network ratings for stocks: Highest Quality, Above Average, Average, Extra Risk, Speculative and Start-up.

Are stock beta ratings a part of your stock evaluation process? How have they influenced you? Share your experience with us in the comments.

This article was originally published in 2016 and is regularly updated.