During the dotcom boom, a lot of folks moved their entire portfolio to technology stocks, especially dotcom stocks because of their spectacular returns.
Slow and stable stocks from sectors like utilities fell out of favor with investors. When the inevitable happened and the market crashed, those who put their money in pure tech stocks were hit the hardest and lost more than the others and the market in general.
What’s surprising isn’t that they lost money or that they lost more than what the market lost but that they didn’t realize this would happen! All stocks carry a ratio that indicates the likelihood of this scenario! Let’s explore what a stock beta is.
This Stock’s Returned 30.53%, 337.35% And 4294.04% In The Past 1, 5 And 10 Years!
Not a household name, but Cliff Natural Resources, an iron and coal mining company, has returned spectacular returns over the past 10 years. It had a healthy profit margin of 26.63% last quarter and a low PE of 12.8.
Would you invest in it?
Let’s say you are a conservative investor with a low risk tolerance, but considering the above facts for this company (hey those are pretty good returns!), you decide to buy 100 shares of Cliff.
The next few days are pretty choppy for the market in general. And then comes the flash crash. You decide to sit this one through and refuse to look at your portfolio.
After 3 months, you decide to review. The S&P has returned negative 8.5% during that period. And how did Cliff do? You lost 29.41%! Woah! You knew the market wasn’t that good, but didn’t expect that much of a decline for Cliff!
Was It Possible To Know This In Advance?
No one can predict how the market will move, but you can mathematically tell how an asset will move with relation to the market. If you look at the above example, when the market was doing well, Cliff returned much more than the S&P 500 and when the market tanked, Cliff lost more than the market.
High Reward, High Risk!
That pretty much sums up this stock! How high of a risk or reward is summed up in a single number called the beta. The beta for Cliff is 2.39. This number tells you how turbulent a stock is, or more precisely, has been over a period of time.
What Is Stock Beta And How Can This Help Me?
Stock Beta is a ratio that indicates how a stock fluctuates with relation to the market. Beta is a indicator of market risk also called volatility. When you research a stock, look at the beta to get an idea as to how choppy the returns on this stock will be with relation to the market. If this doesn’t align with your risk tolerance, this stock may not be for you.
Here are some guidelines on stock beta and what this number means
- A beta of 1: This means this stock is in line with the market. Market usually refers to the S&P 500 group of stocks
- Beta of less than 1: This means market fluctuations affect this stock to a lesser degree (utility stocks)
- Beta of more than 1: This means this is a volatile stock (technology stocks)
- Negative beta: This means that this stock moves in the opposite direction to the market! If the market’s returns are negative, this stock’s returns will be positive! Gold is usually given as an example even though beta shows that though it is less than 1, it isn’t negative.
- Zero beta: This means this stock returns have no relation to the market! Cash in your wallet, lottery are good examples
Remember, beta is calculated with past data and this is not necessarily an indicator of future returns!
Different sites show different betas depending upon what timeline was chosen.
How Do I Calculate The Beta Of A Stock?
You don’t have to! This information is available along with stock metrics on any financial site that lists stock quotes. For instance, here’s an example for Cliff Natural Resources (CLF) from Google Financials.
How Do I Calculate The Beta Of My Portfolio
A simple and quick way to find out if you are an aggressive or a conservative investor is to find the weighted average of all stock betas in your portfolio.
STEP 1: Using the above example, find the beta of your all your individual stocks
STEP2: Find the allocation of each stock in relation to your overall portfolio. For example if your overall portfolio value is $10,000 out of which $5,000 comes from Apple stocks, that’s a 50% allocation for AAPL
STEP 3: Multiply the individual stock beta with the allocation percentage. For example the beta for AAPL is 1.38. 1.38 X 50% = 0.69
STEP 4: Add up all the weighted betas to arrive at your portfolio’s beta
Betas Won’t Save Companies Like BP
Remember beta is simply a technical indicator. Unexpected events will throw this indicator out the window. One good example is BP.
Use betas wisely!
Disclosure: No positions in CLF, long on AAPL