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.
Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.
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 1.5. Apache is down around 27% over the past year.
Dow Component big box retailer Wal-Mart (NYSE:WMT) has a beta of 0.46 making it one of the least correlated stocks to the benchmark S&P 500. Over the past 12-months the discount retailer's stock has gone up approximately 7.21%. 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.
Retailer Nordstrom Inc (NYSE:JWN) has a beta of 1.36 suggesting that the stock is about a third more volatile than the S&P 500 benchmark. For the previous 12-months JWN has gained about 19.82%.
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 roughly 37% over the previous 12-months while CSCO is up nearly 13% over the same time period.
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.
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!