You can get a sense of a company’s share-price volatility based on its stock beta score, but the data can be misleading and it does not really help in selecting stocks for long-term success

Beta ratings are a measure of stock’s volatility in relation to the overall market.

If a stock has a beta of 1.0, then it means that the market and the stock move up or down together at the same rate. That is, a 10% up or down move in the stock market index should theoretically result in a 10% move in the same direction for the stock. A beta of 2.0 implies the stock tends to move twice as much as the market. That is, if the market moves up 10%, the stock should move up 20%. A beta of 0.5 indicates the stock will move one-half as much as the market, either up or down.

A negative beta indicates the stock tends to move in the opposite direction from the general market. That is, the stock price declines when the overall market is rising, or rises when the overall market is declining.

However, while a stock beta score helps quantify that volatility, it can’t give you any real indication of the company’s long-term prospects for safety and growth.

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The limitations of a stock beta score

A negative beta indicates the stock tends to move in the opposite direction from the general market. That is, the stock price declines when the overall market is rising, or rises when the overall market is declining.

As a measure of risk, beta has a number of limitations. It is based on past data, so its use in predicting the future assumes that the underlying company being charted remains unchanged. For example, it assumes that no major acquisitions or divestitures, or other company-changing events take place. In reality, a stock’s beta can rise or fall over a period of years, or change abruptly.

Beta’s can mislead you in other ways. For instance, gold stocks have had an average beta of 0.42 when you use the S&P 500 Index as their benchmark index. Such a low beta indicates that gold stocks are less volatile investments, like utilities. But they are not, of course, and that’s because their performance and returns have relatively little to do with the performance and returns of the S&P 500 Index. They rise and fall with gold prices.

Institutional investors are always looking for so-called “quantitative” measures like beta that can be calculated automatically by a computer program. Beta makes a broad statement about a stock’s history of volatility, but it doesn’t say much if anything about its prospects or its appeal as an investment. To assess a company’s suitability for your portfolio, you are better off using other, more reliable measures of safety, such as steady earnings and cash flow, low debt and a secure hold on a growing market.

Loading up on high beta stocks in a market rise can backfire

We’ve always found betas to be of limited use if any. They provide a general idea of what to expect from a stock, but you should already have that from looking at the stock’s fundamentals. The notion is laughable that you can buy low-beta stocks when the market is going to be weak, and high-beta stocks when it is going to be strong. After all, if you knew when the market was going to be strong or weak, you wouldn’t need to waste time with betas.

While it’s easy to beat the market when the market is soaring, it’s hard if not impossible to predict when the market will start to soar. It’s even harder to predict when a soaring market will reverse course and plunge. This simple fact of investment life causes an extraordinary amount of loss and investor bewilderment. That’s because it’s all too easy to give yourself credit for a gain that you owe to buying a high-beta stock in a soaring market, or just before the market takes off.

If you mistakenly give yourself credit for a gain like this, you may then go on to fill your portfolio with more of the same kind of stock. That can keep on paying off for a time. But inevitably the market quits soaring and stumbles. When that happens, the worst stocks to hold are the high-beta variety. When the market is falling, they tend to fall even faster.

If stocks like these make up a big part of your portfolio, even a mild market downturn can leave you with big losses.

You naturally diversify into high- and low-beta stock market investments when you follow our three-part Successful Investor approach

In a rising market, a high stock beta score tends to jump ahead of the market indexes. However, when the market declines sharply, high-beta stocks can fall more quickly than the market, and be slower to recover. Low-beta stocks may not move up as quickly as the market indexes, but they’re unlikely to fall as far during market declines.

In managing the portfolios of clients of our Successful Investor Wealth Management service, we employ our three-part investment strategy: invest mainly in well-established, dividend-paying companies; spread your investments across most if not all of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance, and Utilities); and avoid stocks in the broker/media limelight.

By doing this, we naturally diversify into high- and low-beta investments. That adds the potential for strong gains when the market is rising, but also adds an element of stability that helps protect your portfolio when the market declines.

Some portfolio managers take on a lot of risk by overloading a portfolio with high-beta stocks. How do you manage the level of risk associated with the stocks you buy?

What are some of the problems you’ve come across with basing stock picks on their beta scores?