Understanding High Beta Stocks

The beta coefficient (b) measures the stock's volatility relative to the market, which by definition has a beta equal to 1.0. The beta of average-risk securities equals 1.0 and their prices fluctuate on average as much as the market. The beta of low-risk securities is lower than 1.0 and their prices fluctuate on average by a lesser amount than the market. This makes low-beta securities less volatile than the market. On the contrary, high-risk securities have a beta greater than 1.0 are more volatile than market because their prices fluctuate sharply incurring a higher risk than the risk of the market.

High-beta securities fluctuate a lot more than the market index, but offer to investors a potential for higher returns. The important considerations when relying investment decisions on beta analysis is to understand the inherent relationship between security beta and portfolio beta. If a security with b>1.0 is added to a portfolio with b = 1.0, then the portfolio beta (bp) will increase. Similarly, if a security with a b < 1.0 is added to a portfolio with a b = 1.0, then the portfolio beta (bp) will decline.

Example

We assume that an investor holds a portfolio of $200,000 consisting of $55,000 invested in each of the three low-beta securities, which have a beta equal to 0.6. The portfolio beta (bp) is calculated as the weighted average of all the individual securities' betas. Therefore:

bp = (55,000/200,000) x 0.6 + (55,000/200,000) x 0.6 + (55,000/200,000) x 0.6 = 0.4950

Since 0.4950 < 1.0, this portfolio is less risky than the market, and experiences narrow price fluctuations.

Now, we assume that a security is sold and replaced by a security with a beta equal to .0.

In this case, the portfolio beta is:

bp = (55,000/200,000) x 0.6 + (55,000/200,000) x 0.6 + (55,000/200,000) x 3.0 = 1.1550

Since 1.1550 > 1.0, this portfolio is riskier than the market, and experiences sharp price fluctuations. Here, the relationship between the beta of a security and the portfolio beta is proved as by adding a high-beta stock the portfolio risk increased.

Now, we assume that a security is sold and replaced by a security with a beta equal to 0.4.

In this case, the portfolio beta is:

bp = (55,000/200,000) x 0.6 + (55,000/200,000) x 0.6 + (55,000/200,000) x 0.4 = 0.44

Since 0.44 < 1.0, this portfolio is less risky than the market, and experiences narrow price fluctuations. Again, the relationship between the beta of a security and the portfolio beta is proved as by adding a low-beta stock the portfolio risk decreased.

By and large, investors should bear in mind that the mathematical equation of beta reflects the stock's correlation and co-variance with the market. In some cases, volatile stocks with low market correlation have modest betas, while stocks that are perfectly correlated with the market have lower volatility. So, the bottom line is that using high beta stocks does not guarantee an upside market rally, while it bears a certainty of a huge downside. Therefore, investors should evaluate the current financial condition. For example, in the currently unstable financial environment, stocks with a beta greater than 2.0 should be avoided.