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The market is still a tad jumpy here in April as investors come to terms with the fact that valuations remain a little stretched and earnings season enters full swing. Small cap and growth stocks are finally showing their true nature again – bouncing around far more than the broad market.
This type of action often leads investors to wish they had a better sense of how far their stocks will move as compared to the broad market.
Thankfully, there is a statistic designed to measure investment risk such as this. It’s called “beta”.
How to Use Beta to Measure Investment Risk
If you ever want to get a better sense of how a stock is likely to move relative to the market, remember to check out the stock’s beta. Beta measures how closely a stock is correlated with the market. A beta of 1 means the stock tends to move the same amount as the broad market (the S&P 500).
A beta over 1 means the stock should move more than the broad market. And the degree of relative movement is measured by the difference between a stock’s beta and 1. For instance, a beta of 1.2 implies that a stock would move 20% more than the market. We tend to measure beta over a period of months, not just one day, so it smoothes out daily volatility.
Take a quick look at Yahoo! Finance and you’ll see that most small cap and technology stocks have betas well above 1. For instance Netflix (NASDAQ:NFLX) has a beta of 2 and Splunk (NASDAQ:SPLK) has a beta of 1.2.
This makes sense, because these stocks tend to have higher return potential than the S&P 500. They’ll move further, faster, and investors must accept more volatility to compensate for greater upside potential.
Beta is directly related to market volatility, and therefore stock market corrections. As I wrote last week, investors should be prepared for a correction in the stock market given valuations, and the fact that we haven’t had a significant correction since 2008.
Preparing for a correction means having some sense of the beta of the stocks you own (ideally, the beta of your entire portfolio, which is considerably more complicated than referencing a resource such as Yahoo! Finance, but still worth considering. For more information, check out Investopedia).
As the chart below from Yardeni Research below shows, we’ve had five significant corrections since 2008.
Understanding your portfolio’s beta during each of these corrections would have helped to reduce investment risk and calm your nerves considerably. Especially since you would better understand the likelihood of those same stocks outperforming the market once the correction came to an end.
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