Build Diversity Through Beta

By Investopedia Staff | November 17, 2010 AAA

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, we'll take a look at how studying the beta of stocks can provide investors with diversification guidance. (To learn the basics of beta, read Beta: Know The Risk.)

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Benchmarking Beta
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 Apache Corp. (NYSE:APA) has a beta of approximately 1. The benchmark S&P 500 is up 6.15%% for the previous 12-months. In line with expectations for a stock with a beta of 1, Apache is down just a bit at 4.6%.

Lowest Beta
Dow Component big box retailer Wal-Mart (NYSE:WMT) has a beta of 0.3 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 1.12%. 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. (For more, see Understanding Beta - Investopedia Video)

High Beta
retailer Nordstrom Inc (NYSE:JWN) has a beta of 1.88 suggesting that the stock is about two times as volatile as the S&P 500 benchmark. For the previous 12-months JWN has gained 16.46% more than doubling the percentage gain of the S&P 500.

Watch for Exceptions
The above examples have traded in a similar fashion as their betas would suggest. However, it is important to remember that beta alone is not sufficient by itself to predict the future movement of a stock. Dow Components Hewlett Packard (NYSE:HPQ) and Cisco Systems (NYSE:CSCO) both have a beta near 1, but HPQ is down 18.5% over the previous 12-months while CSCO is down 19.3% over the same time period.

Final Thoughts
The diversity in betas shown in the above examples is a great start, but given the examples of Hewlett Packard and Cisco, investors should always remember to use beta as a guide to adding diversity and not as an unbreakable measure of stocks future price volatility. (For more, see Calculating Beta: Portfolio Math For The Average Investor) Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

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