Stock Picking 101: Why High Beta Stocks Have High Returns

One factor to consider when picking stocks, particularly when picking stock for the long-term, is to choose stocks that have a higher beta.  Beta is a measure of how volatile the stock is when compared to the market.  Basically a stock that has a beta of 1.00 will move around (have a variance, for those statisticians out there) about twice as much as the market in general.  So if the market has 10% swings, a stock with a beta of 1.0 might be expected to have 10% swings in price as well.  A beta of 2.0 would be twice as wild as the market, and one with a beta of 0.50 would be half as spastic.

The beta of a stock can change with time, with older, established companies having lower betas than newer companies.  This is because their earnings become more predictable, they start to pay a dividend which also adds stability, and because they have more business lines that tend to counter-balance each other.  The beta of a stock may also change for a period of time if there is quite a bit of uncertainty around it for some reason, such as take-over rumors.  Finally, stocks in some industries, such as internet companies and biotechs, will have higher betas than those in other companies such as banks and utilities.  Again, this has to do with predictability of earnings.

Stocks with a higher beta carry more risk.  If a stock may go up or down by 50% over the year, you could lose 50% of your money fairly easily.  If it only tends to fluctuate by 10%, chances are your losses will be lower, given a stable market.  Note that there is no certainty – well established, stable companies run into trouble as well.  Sometimes they become complacent and newer competitors steal their market share.

Because they are more risky, high beta stocks carry a lower price than low beta stocks for the same predicted earnings.  This is because people are willing to accept a lower return if there is lower risk.  Conversely, if people are taking a bigger risk, they want to make more money when things work out to cover the losses in the times things don’t.

Remember, however, that time and diversification both reduce risk.  It would certainly be very risky if you were buying stocks and holding them for a few month or maybe even a year to buy high beta stocks.  Virtually everything known is already priced into the stock – anything you can figure out, others can figure out as well.  If you are buying high beta stocks it is really a coin-flip whether they will go up or down, and they will go up or down a lot more than low beta stocks.

Likewise, if you are buying one stock, your chances are a lot better that you will pick a stock that will grow over time if you pick a low beta stock with solid, predictable earnings growth than if you buy a high beta stock with earnings all over the map.  If earnings don’t materialize you could see a drop in the price and then see the stock sit there for years as the company recovers from its missteps.

If you are buying for the longterm, however, you will see better returns from high beta stocks.  You won’t necessarily know when great earnings will come in that will cause the stock to shoot up, but over long periods of time earnings will grow faster than they will for established companies.  If you are willing to wait patiently, the odds will catch up with you and earnings will rise.

If you are diversifying, you can also afford to buy more volatile stocks.  If you buy ten stocks, while you may have one that simply dies and another two or three that don’t make much progress, one or two winners that grow tenfold can make up for the laggards.  Because they are priced so that, on average, an investor will make a large enoguh profit on the winners to justify the additional risk, if you buy enough different stocks to reduce your exposure to any one position, you should get a better average return than you would have in low beta stocks.

One of the best and simplest ways to take advantage of the high beta advantage is to weight a portfolio heavier in small and mid-cap mutual funds.  There will certainly be times when large caps will do better, but over long periods of time the small and midcaps will do better since their earnings will grow faster and there will be a risk premium  – a reduction in the price due to the additional risk – included in their price.  As the amount of time you have to invest grows shorter and your tolerance for risk declines, money should be shifted into large caps and lower beta investments such as bonds.  When you have years to invest, however, and can put up with the gyrations, higher betas are the way to go.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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