Investors looking exclusively for high-beta-value stocks could miss out on good investment opportunities. That’s especially so when they neglect to look at key measures of reliability and safety in a stock

Beta ratings will help you measure a stock’s historical volatility, but they can’t give you any real indication of a company’s inherent safety or future prospects.

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Making stock picks by measuring volatility is not enough

To calculate a stock beta, a market index like the S&P/TSX Composite Index is assigned a beta of 1.0. The historical volatility of different stocks relative to the index is then measured over a 36-month or 60-month period.

If a stock has a beta of 1.0, it means 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% up or down move in the stock. If you find high-beta-value stocks with a beta of, say, 2.0, it implies the stock will tend 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.

We’ve always found betas to be of limited, if any, use. They help give you a general idea of what you might expect from a stock, but you should already have that from looking at the stock’s fundamentals. The notion is absurd that you can profit by buying low-beta stocks when the market is going to be weak, and high-beta-value 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.

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 the company being charted remains unchanged—in other words, no major acquisitions, divestitures, or other company-altering events take place. In reality, a stock’s beta can rise or fall over a period of years or change abruptly.

The best high-beta-value stocks may have characteristics like steady earnings and cash flow, low debt and a secure hold on a growing market—but then so may a number of other stocks.

Well-established companies are the key to profitable and low risk investments

Instead of moving between extremes of risk, we continue to think investors will profit most—and with the least risk—by buying shares of well-established companies with strong business prospects and strong positions in healthy industries. That generally serves to highlight low-risk investments.

Following that strategy doesn’t mean there won’t be surprises that affect every company in a particular industry. But well-established, safety-conscious stocks have the asset size and the financial clout—including sound balance sheets and strong cash flow—to weather market downturns or changing industry conditions.

By following our three-part Successful Investor philosophy, you naturally diversify into high- and low-beta stock market investments

In a rising market, high-beta-value stocks tend 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.

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 strong market position. Those are the measures we use at TSI Network.

In building a sound portfolio, you should employ our three-part Successful Investor 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, you will naturally diversify into high- and low-beta investments. That adds to the potential for strong gains when the market is rising, but also adds an element of stability that could help protect your portfolio when the market declines.

Contrast that approach to taking on a lot of risk by loading up on high-beta stocks. This may let you show bursts of high performance when the market is rising. However, when the market declines sharply, you could lose far more than the market, and your stocks could be far slower to recover—if they recover at all.

Some investors place a great deal of weight on using beta for stock selection. How closely have you paid attention to it in the past?