The best kept secret of high beta stocks you must know

Lots of buzz goes around the “High Beta Stocks” in the stock market. Traders, mostly the newbie’s, wrongly presume High beta Stocks to generate high returns. Not only new investors, but high beta stocks also lure medium term and long term investors too. Investment in high beta stocks, if not done cautiously, can become a trap for investors.

Thus, It is advisable to understand all the mechanism that involves investing in the high beta stocks before playing with it. Before decoding all the complications involved in trading in high beta stocks for the investors, let’s clear the air surrounding Beta.

What is Beta?

Beta is a statistical measure that denotes the volatility of the stocks in relation and comparison to the entire market. In simple words, beta measures the volatility of the stock.

The market Beta is always 1.

Therefore, the beta coefficient measures the change in the movement of the prices of the stock in either direction as compared to the benchmark. This benchmark in a broader sense is the market, i.e. SENSEX or NIFTY50. But it can also be the index of the companies similar in size or industry.

The stocks those are highly volatile have a beta coefficient greater than 1 and are known as High Beta stocks. The stocks that are less volatile have beta coefficient lower than 1 and are known as Low Beta Stocks. Now as the concept of beta is clear, let’s move forward to understand the concept of volatility and how it is used in trading.

What is volatility?

The fluctuations in the price of the stock as compared to its last traded price are measured by volatility. Volatility is measured over a period of time. The greater the fluctuations, the higher the volatility of the stock is and vice-versa. Furthermore, higher volatility poses a higher risk. It is important to note here that volatility does not only means downside movement. The movement in the price of the stock in either direction is volatility.

Let us understand volatility further with the help of this hypothetical example.  Let’s take two stocks, Yes Bank and SBI Bank.

The beta coefficient of both the stocks is :

Yes Bank-2.05

Sbi Bank-1.05

As we all know by now, that market beta is always 1. If the market moves to any direction whether upside or downside both these stocks will move more than the market movement. If the market falls 5%, Yes bank might fall more than 10.25%, i.e. 2.05 times more and SBI might fall around 5.25%, i.e. 1.05 times more. Yes-Bank with high beta is highly volatile as compared to SBI bank which has lower beta value.

Now the question arises that why is beta important?

It is always in the best interest of investors to diversify the portfolio. Rather than betting on one or two stocks, investors should build a portfolio that suits their investment objective. Portfolio diversification helps in reducing the risk of investment.

However, not all the risks involved in the stock market investing is diversifiable. Theory suggests that there are two types of risks involved in investment in the stock market. We can broadly categorize them as

• Systematic Risk
• Unsystematic Risk

The risk that is inherent to the entire market segment is called systematic risk. Systematic risk is also known as non-diversifiable risk. All investments pertaining to the stock market are exposed to systematic risk. As this risk is inherent to the entire market segment, it is not possible to diversify it.

Let us simplify it further with the help of an example. The global recession of 2008 hit the entire market and not only to a specific industry or sector or any company. The prices of all the stocks fell down badly. This kind of risk that hits the entire market is called systematic risk or non-diversifiable risk. Some other examples of systematic risk include political instability in the country or the situation of war etc.

Systematic risk is measured by the beta coefficient

Unsystematic risk pertains to the risk that is inherent to the investment in any specific industry, sector or company. It is also known as diversifiable risk. The best way to reduce the unsystematic risk is by reducing the exposure of risky securities. The other way to overcome it is by diversifying the portfolio.

For better understanding, let’s take an example.  Suppose, Mr. A who is an investor in the stock market wants to invest in a company XYZ. This company is operating in the pharmaceutical sector. The company awaits a license to deal in one particular kind of drug from the government if the company does not get this license, then there is a risk of the company going out of business. This kind of risk that is specific to the company is called unsystematic risk.

Also, losses pertaining to the labor strike or any event that is not good for the company are the example of the unsystematic risk. The best way to avoid these risks is to diversify investments. As it is a common saying that doesn’t put all eggs in the same basket. Similarly, all the investments should also be spread in various sectors and industries rather than putting all the money in the same stock. The other way to avoid it is to avoid that particular company, sector or industry.

What are high beta stocks?

High beta stocks are those stocks that are highly volatile much more than the market index. High beta stocks offer high return potential, but at the same time, they possess high risk. In other words, the stocks that raise much more than the market gains and that lose more than the market losses are considered as high beta stocks.

Their upside potential is high, but downside risk has no limit too. This is why the investment in high beta stock is considered risky. Only the risk lover investors should invest in these kinds of stocks. Risk-averse investors should stay away from it. When Nifty falls 5% over the period of a month, the stock of CIL falls 10.32% for the same period. It clearly shows that CIL has beta more than 1.

Who should invest in high beta stocks?

Investors who have high-risk appetite should only invest in high beta stocks. High beta stocks have high volatility that means, they offer high returns but at a high-risk premium. Investors with a high-risk appetite can afford to take the risk in investing in high beta stocks and enjoy the high returns offered for taking that risk.

Sometimes, these stocks have high volatility but low liquidity, thus making the risk quotient high. Clearly, these high beta stocks are not for risk-averse investors. Risk-averse investors have a low appetite for risk. Therefore, they should choose low beta stocks. As low beta stocks are not volatile. They do not tend to fluctuate much from their expected return. Most of the utility stocks are low beta stocks.

High beta stocks are market sensitive, i.e. they tend to outperform the market sharply in the bull-run. But, at the same time, in bear run reversal, high beta stocks tend to lose more than the market index. There is a huge risk in investing in high beta stocks, but at the same time, their upside potential is good too.

Traders trading in high beta stocks should actively manage it. It is advisable to have a well-diversified portfolio. By having a well-diversified portfolio, a trader can minimize their losses to a certain extent.

Buy low sell high strategy

Buy low and sell high is the strategy an investor should follow to gain tremendously by investing in high beta stocks. Buying low and selling high means investing in the stock that is trading at a low price and selling it when it is trading at a high price. It is a common practice among traders in the stock market.

As high beta stocks react more than the market benchmark, it is best to apply this strategy to high beta stocks. It is observed that during bear run most of the high beta stocks get in the sharp correction mode. It is a good time to invest in the high beta stocks when the market has entered into a bear phase.

When the market is in the bear phase, prices of high beta stocks fall sharply. As the market enters into a bull reversal phase, high beta stocks recover faster than the market. This is due to their tendency to recovering rapidly and more than the market. Traders having a long position in the high beta stocks can reverse their position at this time. It gives huge returns in short or medium term.

Factors to be considered before investing in high beta stocks

A trader should consider these three important factors before investing in high beta stocks:

• What is the downside limit of the chosen sector/stocks? Does the stock/sector have limited downside or not?
• How significant is the upside potential of the chosen sectors/stocks? If chosen sectors/stocks have an unlimited downside and not the significant upside, then it’s not worth to invest in such sectors/stocks.

• Lastly, is there any proven track record of these companies/sectors of running parallel to the market?

Dos and Don’ts for investing in the high beta stock

Before investing in high beta, stocks trader should consider the following:

• A trader should prefer large-cap companies with a proven track record of financial growth and strong fundamentals.
• Avoid companies with no proven track records.
• Avoid penny stocks
• Don’t invest in high beta stocks if risk appetite is not high.

High Beta stocks vs. Low beta stocks

How and when to calculate and infer the beta of the stocks?

Beta depicts the volatility of the stocks that depends on the movement of the stock market. The market moves sharply on either side during big announcements or any significant events such as elections, budget announcements, RBI monetary policies announcements. These fluctuations in the stock market are termed as market sentiments.

The price of some stocks moves sharply in tandem with the market while prices of other stocks move inversely. Therefore, to enhance the performance of the portfolio, it is advisable to the investors to do the beta analysis of the individual stocks. Apparently, to do the beta analysis, the investors need to know the beta of the individual stocks.

The beta of the individual stocks is readily available in the various reports published by the investment firms. Alternatively, investors can themselves calculate the beta of the stocks. Stock exchanges like NSE do calculate beta of stocks and report it on each scrip page.

The calculation of the beta is relatively simple. For beta calculation, an investor needs two sets of data. Firstly, the closing price of the stocks for the chosen time- period. Secondly, the closing price of the benchmark index over the same time period. Then calculate the daily change in the price of both the stocks and the index.

Daily price change= (Today’s price -yesterday’s price)/Yesterday’s price *100

Calculate the variance and the covariance for stock and the market. Lastly, calculate the beta by using this formula

Beta= (Covariance of the stock and the market returns)/(Variance of the market returns)

The time period is an important factor to consider for beta calculation. Long term investors should use the long time-period to calculate beta. Traders who do intraday trading or those buy and sell for trading purpose and not for investing purpose should use shorter time frames.

What are the drawbacks of using beta in stocks selection?

Beta value comes in handy in the selection of the stocks based on the risk appetite of the investors. However, the beta value is not free from the limitations.

Some of the limitations of using beta value as a determinant of choosing stocks are as follows:

• Beta value is based on the historical price movements, and in certain circumstances, it cannot predict the future accurately.
• It does not take into account the sudden fall in the price of the stock. The sudden fall in the price of the stock is a good opportunity for the investor, but beta does not get adjusted to such change and thus should not be used as a single determinant.
• The beta calculation does not take fundamental values into consideration. If a company has huge debtor has started a new line of business, it will not reflect in its beta value in a short period.

So what you should do with this knowledge on high beta stocks? 

You should use the beta of stocks for your investment decisions cautiously. It must be as per your risk appetite. Risk-averse investors should avoid companies with high beta. These companies are volatile and possess a huge risk. Risk-averse investors should choose utility stocks as they usually have low beta and are therefore less volatile. Investors who are looking for earning a considerable return and also have a massive appetite for risk should choose a volatile company with a beta more than 1.

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