The meaning of beta in stock market investing refers to the historical volatility of a stock. However, it’s important to know about its complexities and limitations as well
Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much if anything about its prospects or its appeal as an investment. To assess a company’s suitability for your portfolio, you are better off using other, more reliable measures of safety such as steady earnings and cash flow, low debt and a secure hold on a growing market.
Here’s a detailed look at the meaning of beta in stock market analysis, and whether it has any value in stock market investing.
The meaning of ‘beta’ in stock market vocabulary
Beta ratings are a measure of stock-market volatility. Stocks with a beta of 1.0 move on average along with the market and with the same degree of volatility, 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.)
The meaning of beta in stock market investing: Beta has a number of key limitations
As a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes the company being charted remains unchanged—in other words, no major acquisitions, divestitures or other company-altering events take place. In reality, a stock’s beta can rise or fall over a period of years or change abruptly.
A stock beta can mislead you in other ways. Gold stocks have a low average beta 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.
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Institutional investors are always looking for so-called “quantitative” measures like beta that can be automatically calculated by a computer program.
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. Those are the kind of stocks we recommend for our clients at Successful Investor Wealth Management.
This balanced approach contrasts with that of some advisors and portfolio managers who aim to load their clients up on high-beta stocks. Of course they can show bursts of high performance when the market is rising. But if 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.
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.
By following our three-part Successful Investor philosophy, you will naturally diversify into high- and low-beta stock market investments
In a rising market, high-beta-value 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. 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 building a sound portfolio, you should employ our three-part Successful Investor strategy: invest mainly in well-established, dividend-paying companies; spread your 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.
By doing this, you will naturally diversify into high- and low-beta investments. That adds to the potential for strong gains when the market is rising, but also adds an element of stability that could help protect your portfolio when the market declines.
Stock beta can be problematic when used in isolation. What do you look for in addition to, or in place of, a stock’s beta?
Using a stock’s beta can make it seemingly easy to choose an investment, but that comes with risk. What kind of investments have you made based on beta only to find out later that you should have looked at other indicators?
