stocks are often considered risky, and at times they are.
However, investors should understand the difference between risk
and beta, because while the risk level of a stock is sometimes
reflected in its beta, there's more to the story. Let's take a
closer look at what beta is and what purpose high-beta stocks can
serve. As an investor, it's critically important that you really
have a good grasp of this concept so that you can more
effectively use the beta metric when evaluating a stock for your
Before we dive into high-beta stocks, let's briefly go over
what beta really means.
What beta means
Beta measures how much a stock price tends to move in either
direction compared to a benchmark. Typically, that benchmark is
the broader stock market or
, but it can also be an industry or an index of companies similar
in size. Beta is a measure of
, not a measure of risk.
The beta scale works like this. A stock with a beta of 1 has
moved in lockstep with its benchmark over the measured period of
time. A beta of less than 1 means the stock was
volatile than its benchmark, while a number greater than 1 means
volatile, exaggerating the benchmark's moves. Meanwhile, a stock
beta tends to move in the opposite direction of its
It's also important to understand which beta measure you're
looking at. The most typical beta metric listed with a stock
quote is its three-year beta versus the market, but this can be
different from one source to the next.
What are high-beta stocks?
A high-beta stock, quite simply, is a stock that has been much
more volatile than the index it's being measured against. A stock
with a beta above 2 -- meaning that the stock will typically move
twice as much as the market does -- is generally considered a
high-beta stock. High betas are typical of small, speculative
companies -- e.g., biotech companies that are developing new
treatments and small tech stocks with hot new technologies that
have big potential but small market share. Because the price of
these sorts of stocks can swing wildly, and often on little more
than speculation, this volatility can make the shares seem risky
if the shareholder reacts to the price movement and sells at a
Beta is often used as a proxy for risk, and indeed high-beta
stocks often carry more risk, but a high beta doesn't guarantee
high risk any more than low beta guarantees low risk. Before we
talk any more about beta and risk, let's define risk as the
likelihood of a
permanent loss of capital
Here's an example of how risk and beta don't always align.
Let's say you could invest in either of the following:
- Company A has been in business for almost 100
years, with expertise that makes it a leader in a
fast-growing global market. The stock has been volatile, but
the business' balance sheet is solid, and the company has a
long history as a supplier to major players in this growing
space. It has grown sales more than double since 2010.
- Company B faces stiff competition in its business, has few
competitive advantages, and faces the threat of declining
market share as consumer tastes shift away from its offerings,
as evidenced by its minimal growth of sales -- only 26% since
2010, significantly lower than its peers. With similar revenue
to Company A, Company B generates less than half the net income
while carrying only about 40% as much cash on its balance
Which of these two would you expect to carry more risk of
permanent loss of capital?
If you said Company B --
Red Robin Gourmet Burgers
-- you'd probably be right. However, the restaurant chain had a
beta of about 1.3 at the start of the year, while company A --
-- had a beta around 2.4 and has consistently carried a higher
beta for years. Only in recent months have these companies' betas
begun changing course:
Red Robin faces serious long-term competitive threats to the
viability of its business, while Chart Industries is a recognized
global leader in the industrial cryogenic liquids processing
business. Those risks didn't just show up this year, either, so
in many ways, beta is more of a trailing metric, reporting past
volatility rather than today's risk.
Real-world business challenges are not factored into beta, but
rather mere market volatility, which is a measure of the market's
of risk and is short-term in nature.
A few words on business-focused investing
While beta can be a helpful metric when used in combination
with other tools, remember that it's only a measure of past
volatility against an index -- not a measure of safety. When
researching any stock, study the whole business, looking for
durable advantages. Never rely on metrics alone to tell you
whether a company makes a good investment.
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Investing Essentials: High-Beta Stocks
originally appeared on Fool.com.
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