Stocks can be high beta or low beta. What's the difference between the two types, and which is best for you?
To begin with, we should familiarize ourselves with beta (or "the beta coefficient"). Alpha and beta are among the most important concepts for investors. Both are related to the CAPM (capital asset pricing model), which is used to derive the expected return on an asset.
In technical terms, beta measures the systematic risk of any asset, or the risk that's beyond companies' control. It's also known as a "non-diversifiable risk," as you can't lower systematic risk by diversifying your portfolio.(Think of it this way: when the S&P 500 crashes, stocks fall across the board.)
Beta in stock market investing
Beta measures the volatility of a stock compared with that of the benchmark index. A beta of one implies that the stock’s price action tracks the index. So, if the index goes up by 10 percent, the stock also rises 10 percent.
Stocks with a beta above one are expected to rise or fall more than the benchmark. Similarly, if a stock’s beta is less than one, it's expected to rise or fall less than the index.
What are high-beta stocks?
High-beta stocks are more volatile than the broader market. By definition, these are high-risk stocks. In a rising market, high-beta stocks tend to deliver larger returns than the index. However, when the market falls, they tend to fall more than the index. Usually, growth stocks, cyclical stocks, and stocks of non-discretionary consumer companies are high-beta stocks.
What are low-beta stocks?
Low-beta stocks are less volatile than the index. Their return tends to trail that of the index in a rising market. However, when the index falls, they tend to fall less than the market. Consumer staple companies, pharma companies, and utility companies generally have low-beta stocks. Most are value stocks and pay a high dividend.
A stock can also have a negative beta, meaning that its price action is the opposite of the index's. (So, a beta of −1 would mean that the stock rises 10 percent when the market falls 10 percent.) However, in reality, a stock can't have a negative beta over an extended period.
Should you buy high-beta or low-beta stocks?
Whether you invest in low-beta or high-beta stocks depends on your risk appetite. If you're comfortable with higher risk in exchange for better potential returns, you should allocate more of your portfolio to high-beta stocks, and if you have a low risk appetite, you should lean toward low-beta stocks.
Allocating your portfolio tactically with high-beta and low-beta stocks
You could also increase or decrease your portfolio allocation toward high-beta and low-beta stocks tactically. When the economy is looking strong, it makes sense to have a larger high-beta allocation, and if the economic outlook looks bleak, more low-beta exposure is often better.