In conjunction with stock valuation ratios like the price-to-earnings ratio and the price-to-earnings-growth ratio, a stock's measure of volatility known as beta can help investors build a diversified portfolio. In this article, I'll show how studying the beta of stocks on Dow Jones Industrial Average can provide investors with diversification guidance. (To learn the basics of beta, read Beta: Know The Risk.)
Using the S&P 500 as a benchmark for beta, investors can determine how a stock may perform in relation to movement of the broad index. If a stock has a beta of 1 then it is expected to move up and down in tandem with the benchmark. A stock with a beta of 1.10 is expected to rise or fall 10% more than the benchmark. Conversely a stock with a beta of 0.80 would be expected to move up or down only 80% as much as the benchmark. In short a higher beta equals greater volatility, while a lower beta equals less volatility.
For example chemical company Du Pont (NYSE:DD) has a beta of approximately 1. The benchmark S&P 500 is down nearly 43% for the previous 12-months. In line with expectations for a stock with a beta of 1, DuPont is down just a few percentage points more at 46.5%.
Dow Component big box retailer Wal-Mart (NYSE:WMT) has a beta of 0.1 making it one of the least correlated stocks to the benchmark S&P 500. Over the past 12-months the discount retailers stock has gone up approximately 12.4%. While beta may have been a good indicator to lead investors to Wal-Mart, investors would still have to examine the combination of low prices, proximity to consumers and a the effects of slowing economy as factors in the external environment supporting the stocks upward progress.
Aluminum maker Alcoa (NYSE:AA) has a beta of 2.1 suggesting that the stock is more than two times as volatile as the S&P 500 benchmark. For the previous 12-months AA has lost 74.9% of its value nearly doubling the percentage loss of the S&P 500. External factors concerning the global economic slow down and a possible decline in demand from Asia contributed to the stocks decline.
Watch for Exceptions
Exceptions to the rules exist reminding investors that beta alone is not sufficient by itself to predict the future movement of a stock. Dow Components Hewlett Packard (NYSE:HPQ) and General Electric (NYSE:GE) both have a beta of approximately 1, but HPQ is down 31.7% over the previous 12-months while GE is down 60% over the same time period.
By simply mixing high, mid-level and low beta stocks from the Dow Jones Industrial Average, investor gain exposure to a cross section of industries including diversified chemicals, retail, technology, automobile and industrial materials. The diversity is a great start, but given the examples of Hewlett Packard and GE, investors should always remember to use beta as a guide to adding diversity and not as an unbreakable measure of stocks future price volatility.