As featured in the Herald Sun – Friday 14th October 2016.
By David McCulloch – Market educator and consultant to Share Wealth Systems
Beta is a historical measure of the risk of holding a stock, or even an entire portfolio when compared to the market as a whole. To keep things simple, a stock with a beta of 1 basically means that the stock is likely to match the performance or movement of the overall market over a period of time. In this sense we can also use a stocks beta as a measure of volatility. Volatility as the term suggests refers to price movement both upwards and downwards. Stocks that have a historically high volatility are likely to experience fairly large swings in price when compared to lower volatility stocks. So which is best, high beta or low beta?
Let’s explore a little further. A stock with a beta of 1.5 means the risk of holding it (based on historical movements) is 50% higher when compared to the overall market. If the overall market gained 10%, we could expect the stock to gain 15% and this might initially sound like an attractive proposition. We also need to think about the risk of movement in the other direction and a stock with a beta of 1.5 is also likely to be more volatile on the downside. For example, if the overall market lost 10%, it is likely that the stock could lose 15%. So in effect beta is trying to help us measure the risk in terms of volatility into the future. Typically, higher returns are associated with higher risk. Knowing your own risk profile can be helpful when building an investment portfolio and there are many different ways to do that. A go slow approach for someone that is very risk averse might be to hold only very low beta stocks in their portfolio, or a couple of low beta ETF’s. For someone with a higher risk profile a portfolio of higher beta stocks might be more appropriate.
Remember, investing is a risk management process and having some clear risk management rules can certainly help to minimise adverse movements. There is no certainty with any stock, ETF or portfolio and a stock’s beta only provides a historical measure of risk. High beta stocks are likely to outperform the market when the market is doing well, but underperform when the market is not doing well. The key here is to be able to identify those periods of relative outperformance and stay with those stocks and ETF’s while in that phase. Once that phase is showing signs of weakness it would then make sense to switch out of that holding. Common sense would suggest that as the market starts to weaken, the risk that the stock weakens at a faster rate may also increase. In this way an investor can take advantage of higher beta stocks by becoming a little more active and not simply taking a buy and hold forever approach. The simple use of a trailing stop is just one example of a methodology than an active investor can use to their advantage in this regard.
David McCulloch is a market educator and consultant to Share Wealth Systems.