Let’s get the facts straight: low beta does not mean low volatility and it definitely does not mean low risk.
This is a common misunderstanding that even so called “experts” get wrong. Watch, listen, or browse your favorite financial media source and you are sure to find more incorrect explanations of beta than correct ones.
It might be helpful to first understand beta. It is a financial term used to describe the correlated volatility of one equity to another over a specific period of time. Typically, that correlation is to the S&P 500 for the past 30 trading days. The key word is correlated.
If an equity has a beta of 1, that means that it is correlated with the S&P 500. So, if the S&P 500 went down 1%, we see that the equity also moved down 1%. If the S&P 500 went up by 1%, the equity would have moved up by 1%. Consider the SPY, it has a beta of 1.00. The SPY is not the S&P 500. It is an ETF that resembles the S&P 500. Sometimes there is a little slippage and the beta can be a little higher or lower than 1.00 for the SPY.
If an equity had a beta of 2, that would imply that it moves in the same direction as the S&P 500, but by twice as much. So, if the S&P 500 went down 1% we can expect that the equity moved down by 2%. In this case, it is correct to say that the equity would be more volatile than the S&P 500. In fact, it would be twice as volatile. A good example of these are some of the leveraged ETFs which strive to reproduce a multiple of the daily move of an index. The SSO is the 2x leveraged ETF for the S&P 500. It has a beta of 2.03.
Seems simple enough.
Beta can also have negative numbers. If the beta was -1, that would imply that the equity moved by the same percentage as the S&P 500, but in the opposite direction. The SDS which is the 2x inverse leveraged ETF for the S&P 500 has a beta of -1.72. (Note that it is not exactly -2. That has more to do with the shortcomings of leveraged ETFs.)
Where beta becomes confusing is when beta is less than 1. That can mean two things:
- It moves with the S&P 500, but with less magnitude or it is “muted.”
- The equity is not well correlated to the S&P 500.
Of these two reason, it is the latter that is the most common reason for a low beta. Low beta usually means that the equity just does not move with the S&P 500. It could be more volatile or less volatile than the S&P 500. With low beta you cannot conclude anything about the volatility.
Low beta stocks can, and often do, have high volatility.
That comes as a shock to many people. Especially to people who purport to be risk averse and therefore chose to trade low beta stocks. It sound reasonable. However, it could not be further from the truth.
If you wanted to compare the volatility of different equities you need to look at the standard deviation or the historic volatility. Either is an acceptable way to consider an equity’s volatility. Standard deviation or historic volatility will give you an apple-to-apples comparison. These are simple to calculate, but unfortunately they are not available on a lot of the popular stock quoting services.
(It is important to note that there are different conventions for calculating beta, historic volatility, and standard deviation. If you find a source that provides the information and it is reliable, stick with that one source. Do not compare data from different sources unless you are sure of how these numbers are calculated.)
Consider some of these equities:
|SPY||SPDR S&P500 Trust ETF||1.00||13.8%|
|GMCR||Green Mountain Coffee Roasters||0.92||62.4%|
Source for Beta: www.finviz.com. Historic volatility was calculated using Excel.
There are some interesting comparisons here. However, I think the most noteworthy example is Netflix (NFLX.) With a beta of 0.79, Netflix is considered a low beta stock. If you don’t know anything about Netflix and you misunderstand beta, you might be tempted to think it is a low volatility stock. However, quite contrary, with a historic volatility of 138.6% it is a very volatile stock.
The key take-away here is that low beta does not mean low volatility. Beta is only an indication of the correlation to an underlying index. Don’t think that because you have a low beta stock, it is low volatility.