Since 2007, the simple mention of the word "volatility" has been enough to make most investors cringe. Many people would rather just avoid the market's hiccups altogether. But what if I told you there was a way to use a stock's volatility to your advantage and potentially increase your profit potential?
Beta, and how to use it
Beta is a metric that uses historical price data to tell you whether a stock is more or less volatile than the market. A stock with a beta of 1 will move in tandem with the market. But if stock XYZ has a three-year beta of 1.50, that means that if the market as a whole were to rise by 10% over that period, we would expect to see a 15% rise in XYZ. Conversely, if the market dropped by 10%, we would expect XYZ to fall by 15%. The higher the beta, the more volatile the stock.
If you believed in the prospects for a bull market, picking out high-beta names could give you the opportunity to outperform the indexes to the upside. Likewise, if you're more risk-averse or think the market is ready to fall, a low-beta stock could help preserve your capital and reduce dramatic price swings in your portfolio.
Let's look at an example in each scenario and see how they can help you potentially make money.
Targeting high-beta companies
Sectors that are more susceptible to the peaks and troughs of the economic cycle are more likely to have higher betas. Technology is a good example. It's most often the first sector to rebound with a vengeance out of a recession and one of the first to freefall when the market heads lower. For those out there with an appetite for risk, a high-beta tech company may be just what you're looking for.
One name that stands out in this sector is Telestone Technologies (Nasdaq: TSTC), a company supplying networking solutions to China's 3G networks. If you anticipate a boom in China's wireless-communications market, you'd be wise to seek out a company like Telestone, which has its technology firmly entrenched in the 3G market.
Telestone, with its three-year beta of 3.55, provides the potential for appreciation and index outperformance that more risk-friendly investors with long time horizons should be looking for.
Stabilizing your portfolio with low-beta companies
Although the economic news confirms that we're out of a recession, some economic bumps remain. Companies with low betas can stabilize your portfolio during volatile times such as these.
My favorite sector to turn to for capital appreciation with relatively minimal price fluctuations is Utilities -- and my favorite company in this sector is Duke Energy (NYSE: DUK), which provides electricity and natural gas, two essential staples. Although the economic cycle does have some bearing on its business, people will still use electricity and natural gas regardless of how bad things ever get.
Duke Energy has a three-year beta of 0.45 -- making it less volatile than the market as a whole -- and a healthy dividend of 5.5% per year. Over the past three years, including dividends, Duke Energy has risen by 12% while the S&P 500 has fallen by 25%. Although you can't eliminate your investment risk, tapping into low-beta companies such as Duke can reduce the amount of volatility your portfolio is exposed to.
Proceed with caution
Beta is not without its flaws, and you shouldn't use it as the sole basis by which you choose an investment.
One problem is that beta doesn't consider a company's underlying fundamentals. Earnings growth -- or a lack thereof -- is the primary driver of a stock's price. Beta doesn't take earnings growth into account, but it's something you shouldn't ignore. Take Ambac Financial (NYSE: ABK), for example. If you expected rapid economic growth and relied only on Ambac's three-year beta of 3.07, you'd have completely missed its most recent 10-Q, which hinted at a possible bankruptcy.
What's more, beta implies that a stock has just as much of a chance of rising as it does of going down, and that's not always the case. It also factors in only historical price data, so it doesn't differentiate how investment-worthy a stock is based on price. Is Telestone Technologies as good of a buy at $30 as it is at $10? Probably not, but beta leads us to believe so.
Your Foolish takeaway
Beta is another piece in solving the investment puzzle. It can help you increase profits in bull markets and somewhat shield you in bear markets, but you have to look at it objectively, and in tandem with other metrics, before making an investment.
Do you have a favorite beta play? Let’s hear about it in the comments section below.
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