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.
April 09 2010 – You buy 100 shares of CLF at $74.83 You feel pretty good about your purchase!
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!
Jul 09, 2010 – You decide to take the loss and sell your holdings in Cliff
Fast forward 12 months. You are curious how Cliff did even though you’ve sold your holdings. April 09 2011 – S&P’s recovered to 12.74% and Cliff? It’s returned 36.42%!
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
Excellent intro to the concept and use of beta. Understanding volatility of stocks and portfolios is important. It will help a lot of your readers!
I liked the expressions on the faces.
Thanks DIY! I don’t trade purely on technicals, but I find beta to be quite useful especially for unknown stocks.
Ironically, I owned BP. And since Cliff Natural Resources is in my backyard, I’ve been flirting with buying it too (especially give the trace elements concerns).
Great write-up on beta!
I too own BP, MR! Bought right after the disaster. I might consider CLF.
I owned it before the oil spill disaster. I got out before their share price dropped too low though (whew).
They had an 8% dividend yield back then.
Thanks for the detailed explaination of Beta. Now I know why my stomach is always in knots. It’s because of high Beta. That third picture looks like me when I sell low after buying high!
LOL! You crack me up Buck!
Hi MoneyCone,
Great job on describing betas. I remember when I first started investing, the stock market was no better than a casino. Many people try to wade through stoks without really knowing what these numbers mean.
A quick education reading articles like this will really benefit people in their stock purchases. A detailed stock quote may seem like differential equations to some people, but they really aren’t as scary as they look.
Once you get a grasp of what each of those ratios, acronyms, and numbers means, you’ll have a much better time picking your investments. No more casino tricks, pick your stocks wisely by getting educated! Great article MoneyCone!
Thanks,
Timothy
Well said WA! Thanks for the kind words!
Money Cone, excellent post!
and a good comment from Wealth Artisan as well.
Glad you liked it Ninja!
Nice! I can tell that you put so much heart and effort in your posts. Did you design the men with the faces yourself?
Excellent review on beta. I remember in my finance class how lost I was when trying to calculate it myself using the CAP model. It sucked. It’s a good thing we live a a technological “google” world.
Romeo
Thanks Romeo! I’m no artist by any stretch of imagination! These are called rage comics and there are online tools to create them.
CAPM is a pain – thank heavens for online tools!
Great article! I’m a big fan of looking at beta because of the ETF portfolio I proposed on my website. I’m more of a slow and steady guy so I chose lower volatile components as the core of my balance sheet and put only 20% weight on very volatile instruments.
Fan of reddit much?
-Ravi Gupta
That’s a good strategy Ravi!
I love reddit!
Beta has no direct impact on my portfolio because I use protective puts for every stock I hold. The situation you describe is a perfect example. There is no way that I can lose 30% even during a flash crash because of the puts. The last time I checked, I faced a maximal liability of about 6.5%. Using the puts has allowed me to take the emotion out of the equation and hold on during volatile times.
Interesting strategy you got there OD!
I saw enough damage to my retirement account with the tech bubble bursting and watching Worldcom go bankrupt. So, in 2007 I started buying put options on every stock I owned. It served me well when the market dropped almost 40%. I only lost 18% and bounced back rather quickly.
Good to know OD! Looking forward to that post! I love personal stories of triumph!
When I read the section header “how do I calculate the beta of a stock” I thought you were actually going to break it down! That would have been way too much for a Sunday read lol. But this is a great intro to beta, I like the example you used. There are still many investors that don’t know how to incorporate a stock’s beta into their portfolio strategy. nice job.
Hehe! Wouldn’t want to ruin anyone’s Sunday! Work smart not hard – that’s my philosophy LaTisha!
Nice review and of beta, good refresher course
It was a concept I enjoyed learning about back in business school, though I don’t focus on it these days in terms of stocks. Still, conceptually, it’s good to know – particularly if you’re investing in individual stocks or constructing your own portfolio.
Personally, in terms of risk, I’m finding that I’m changing a bit as I get older. I’m becoming more risk averse with savings, but am willing to set aside small amounts for specifically designated “risky” ventures.
Setting a limit on how much risk you are willing to take is always a good move whether it is Las Vegas or the stock market!
That’s a great review of beta, and some nice words for market investing in general. My dad always told me to buy and hold, and not worry about what the rest of the market was doing – A lot of people sold at the bottom of the last recession because they were scared of what would happen, then missed out on all of the big returns after.
You have to have an iron stomach sometimes in the market.
‘Be fearful when others are greedy and greedy when others are fearful’. You put it very nicely Jeff!
Nice treatment of beta. I’m always happy to see investment concepts applied simply and clearly! This wone’s going in my next roundup.
Thanks much Barb!
Great article, MC.
Beta is one indicator I look at when I want slow and boring, and the Google Finance tool is the same one I use. I like the fact that it shows the percentage of institutional ownership right under it. Stocks with high institutional ownership seem to have higher betas.
Interesting observation 101C!
The simpler, the better. I am impressed by how you turned an utterly difficult finance/MBA topic into this. I think individuals who are interested in investing will find this very helpful and convenient. I personally am risk averse but it is true that if you want to accumulate wealth fast and furious, go for high risk and high returns. But you also have to possess a keen sense of the effects of the market velocity. Some rely on hunch but I say hire an accountant and really discuss it especially for substantial investments. You can also try speculation or forex trading for fun and fast earnings (or losses).
The simpler, the better. I am impressed by how you turned an utterly difficult finance/MBA topic into this. I think individuals who are interested in investing will find this very helpful and convenient. I personally am risk averse but it is true that if you want to accumulate wealth fast and furious, go for high risk and high returns. But you also have to possess a keen sense of the effects of the market velocity. Some rely on hunch but I say hire an accountant and really discuss it especially for substantial investments. You can also try speculation or forex trading for fun and fast earnings (or losses). Derivatives are deregulated markets so you might just want to try that.
Thanks for explaining the Beta. This is very helpful as I have a lot of questions on Beta. An investment concept executed simply and clearly is always the best.
Glad you find it useful!
Two facts, as food for thought:
- Only 202 of the 500 biggest companies in the United States in 1980 were still in existence 20 years later.
- On December 29, 1989, Tokyo’s Nikkei stock average reached its all-time peak of 38,915.87. Twenty years later, the Nikkei has never again reached that level — and, in 2009, reached a new low of 7,054.98.
Good reminder that there are no guarantees with the stock market
I take a contrarian approach to investing— when the Gulf oil spill looked the bleakest was the best time to invest in BP.
Value investing will never go out of style!
I guess I have a tendency to prefer low beta stocks, but I didn’t know that until I read this! Thanks for info – I’m going to calculate my portfolio beta now
Excellent description of Beta. Investopedia couldn’t have done it better. I’m a nerd when it comes to modern portfolio theory, can’t get enough of it.
Thanks for the kind words Hunter!
Never heard of the concept of the “beta” before. Your blog keeps getting deeper and deeper.
I’ll take that as a compliment!
Good to be on top of your portfolio!
Fantastic post MoneyCone! I always wondered what Beta meant… Thank you