What is Beta?
BETA—A measure of the volatility of a security compared to the market as a whole.
Beta is a simple measure of volatility of an individual security relative to the market as a whole. Beta is primarily used in capital asset pricing models to help determine position size based on expected volatility. But, you don't need a fancy pricing model to benefit from understanding Beta. Let's dig a little deeper.
To simplify, here is how we look at Beta. A stock with a Beta of one, means every time the overall stock market—say, the S&P index—rises 1%, we expect that stock to rise 1%. The same applies for a decline. The point is, the stock won’t outperform or underperform the overall market based on its trading history.
Understanding Beta can be helpful because it allows you to juice the performance of your portfolio, without having to increase position size. Let’s see how that works by looking at AMD.
First, let’s take a look at Finance Yahoo to see what the Beta of AMD is. We can see in the second column above that it is 1.95. For simplicity, let’s round it to a whole number of 2. With that number 2 in mind, we roughly expect AMD to double the size of the move that the SPX makes. It isn't always that way, but based on the stock's history, a Beta of 2 means it doubled the size of the moves historically.
One of the first things you will notice on AMD is the size of the drawdown from its 52-week high down its 52-week low. While the overall market also declined since the beginning of the year, AMD magnified the decline by a substantial margin. Next, take a look at the rally out of the summer low. When the market indexes bottomed in June, AMD did as well. Out of that low, the SPY rally just shy of 20%. Not bad for a counter trend rally, right? But let's look at what AMD did.... Over 40%! That is what we would expect given its high Beta, and that is what it gave us.
With a Beta of 2, we expect AMD to double the performance of the SPX. In theory, that means you can achieve the same performance with half of the shares.
For example, let’s assume the SPX was sitting on major support and you expected the indexes to rally by roughly 10%. In order to achieve a 10% portfolio return, you would need to invest 100% of your portfolio to the SPX index and hold on while it appreciates to your target.
Now, let’s look at how we can achieve the same result, but without committing all of our funds. AMD has a Beta of 2, making it twice as volatile as the SPX. In theory, AMD should rally 20% if the SPX climbs 10%. That means you can achieve a 10% portfolio return with half the capital it would take if you bought the SPX directly. Again, this is in theory. In real time, anything can and will happen. To be clear, we are not recommending anyone put 50% of their portfolio in a single high Beta stock. But having knowledge of Beta can help you juice your returns when applied properly.
Types of Beta Values
If a stock has a Beta of 1, its price activity has a very strong correlation with the market. If the S&P 500 rises 1%, then historically, the stock is expected to do the same. Blue chip stocks often have a Beta close to 1.
If a stock has a Beta lower than one, then it is likely not much of a mover. The stock has less volatility, and theoretically, it carries less systemic risk than the overall market. Note, Beta can’t detect unsystematic risk that is unique to an individual security. For example, Beta wouldn’t be able to predict a sudden price movement due to a buyout offer, or a surprise news announcement. That is why we never rely on Beta alone when we are considering how to construct our portfolio.
A Beta value greater than one is assigned to stocks that move on a percentage basis by more than what the market does. For example, AMD has a beta of 2, making it twice as volatile as the SPX.
Technology and small-cap stocks tend to carry higher Beta values than blue chip stocks do. That means if your portfolio is full of tech stocks, you stand a chance of outperforming the market indexes in a bull market, but you will likely underperform on the way down.
When to Consider Beta
It is easy to get too complicated when it comes to how to utilize Beta. But, it doesn't have to be. In general, when we believe we are near a major market bottom, we try to obtain leverage by purchasing higher Beta stocks. This theoretically allows us to outperform on the way higher, if the market cooperates. But, when we are in the middle to late part of a cycle rally, we like to dial our Beta back so our drawdowns are mitigated.
As always, there are exceptions, but increasing Beta early in a bull market and decreasing Beta late in a bull market will tend to ramp up your returns on the way up, and reduce your drawdowns on the way down. Any tool that helps to outperform the market is worth consideration. We think Beta is just such a tool.
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