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Friday, March 11, 2011

Understanding high beta stocks

A high 'beta' stock has price movements similar to a larger group of stocks known as an index. The beta, also known as the 'beta coefficient', is a mathematical result calculated by recording changes in stock price over time and comparing those changes with changes a group of other stocks. For example, if XYZ has a beta value of 1 as measured against an index of stocks in the same industry, then XYZ has price movements similar to the average or weighted average of the larger group of stocks; this relationship is called correlation.

How beta is interpreted is also important as simply knowing a financial security has a high correlation with other securities only says that financial instrument performs in an average way in comparison to other financial instruments. For this reason understanding what high beta stocks are also involves interpretation of the beta value in each particular measurement.

How a high beta stock is defined

To illustrate a high beta stock, suppose there is a company with an unknown historical price performance in relation to a broad based market index. That company has a 52 week price range of $10-$40 per share which in and of itself is an indication of past price volatility. However, if that volatility closely matches that of 100 other companies all in different sectors of the economy, then the probability increases the beta is indicating an overall market movement rather than a company specific matter. The following video provides additional explanation of the beta concept:

Since beta values often range from -1 to +1 with +1 meaning high correlation, and the inverse for the negative, then a number close to +1 would be 'high beta'. I the company performs negatively when the overall market does well, then the chances the company has a specific problem increase and the beta has a lower value. Thus, beta should not only be understood as a variable in and of itself, but also in relation to other financial and economic situations.

Why high beta stock assessments are useful

Beta values are used by investors, financial analysts, and other financial aficionados to better understand risk, potential and performance of financial instruments such as individual company stocks. For example, an analyst may want to compare the beta value of XYZ company in relation ABC Index with the beta of EFG company in terms of the same ABC Index.

This allows the analyst to not only determine which company has most closely conformed with average price movements, but which company is more volatile and hence riskier. Beta values can be used in different ways for different assessments; they can be used when planning an investment strategy, in retirement planning, in forecasting performance and more.

Other uses of for high beta stock values

High beta stocks may be further analyzed using the same high beta variable discussed above. This is because the beta coefficient is also used in other financial formulas and is a resulting variable of regression analysis. In other words, the beta coefficient is both a variable and an outcome depending on the financial measurement involved. Since regression analysis measures relationships between financial variables it logically follows that the beta coefficient would be a result of that technique.

In the case of the Capital Asset Pricing Model (CAPM), pricing of an asset is determined in part by measuring volatility. Beta is a variable that measures volatility in terms of comparative price movement, and is consequently widely known to be used in CAPM. A high beta stock might cause a stock measured with CAPM to be worth more if the index against which the stock is being measured is performing well, and vice versa if the situation is otherwise. To calculate beta, the method used in the following instructional video may be used:

A high beta stock is one with a value closer to +1 or higher. This value measures comparative change over time and is a historical value. Since beta is historical, it doesn't necessarily predict future price movements with great accuracy. Nevertheless, knowing the beta of a stock can be helpful when making financial decisions, especially when understood in the context in which the value is used.

A high beta stock isn't necessarily a good thing as the beta may reflect a tendency to perform on average. However, in some cases a high beta may be good, such as when one sector of the economy is performing better than other sectors and the beta for a particular stock with stocks in that sector is high.