Most investors seek out investments that will give them the biggest gains they can get. High beta stocks are a favorite of many investors who aren't afraid of taking big risks in order to earn jaw-dropping returns.
So what exactly are high beta stocks, and is investing in them all that it's cracked up to be? Let's take a closer look.
Economists use the Greek letter beta as a measure of volatility in the way an investment's price moves. A beta of 1 indicates that the stock generally moves with the same amount of volatility as the broad stock market. Stocks that don't move as much as the market earn lower beta values, while high beta stocks tend to be even more volatile than the market as a whole.
The reason so many investors are drawn to high beta stocks is because they're the companies that really move. During bull markets, no one wants to be stuck with a stock that can't even keep up with the S&P 500. High beta stocks tend to be market leaders during the most positive times for the market, and they therefore coincide well with most investors' temperament.
For instance, over the past year, the stock market has risen by about 13%. But several high beta stocks have produced much stronger gains. 3D Systems (NYSE:DDD), for instance, has ridden the wave of interest in 3-D printing to a 163% gain over the past year, and it has a beta of well over 2. Cheniere Energy (NYSEMKT:LNG), which is in the middle of building a liquefied natural gas export terminal on the Gulf Coast, has been especially volatile, with a beta of nearly 4, but a return of better than 75%. You'll also find several housing-industry plays among high beta stocks lately, with homebuilder PulteGroup (NYSE:PHM) and drywall specialist USG (NYSE:USG) among those that have more than doubled in price since late 2011.
The paradox of beta
Interestingly, though, when you look at longer-term performance, high beta stocks don't always hold their own. Sure, if you pick the right high beta stock, you'll end up rich. But overall, a lot of high beta stocks crash and burn, pulling down the average returns for the entire group.
By contrast, stocks with less volatility often perform better over the long haul. That flies in the face of conventional economic theory, which argues that higher risk should bring greater rewards. But earlier this year, Daniel Morillo of iShares Investment Research shared his thoughts about why low-volatility stocks outperform their riskier counterparts. Morillo's argument is that because professional money managers get paid based on relative performance against an index rather than absolute long-term performance, they have an incentive to focus more on beating the market in any given year. Because the stock market rises more often than it falls, more volatile stocks that are correlated with the market's move should produce outsize returns more often than not.
As you'd expect, when money managers are pushing into one set of stocks hand over fist while ignoring another set of less exciting companies, you'll get better deals by avoiding the popular, overpriced investments and choosing unloved low-volatility stocks instead.
Even if low beta stocks have better long-term returns, you don't need to give up on high beta stocks entirely. But if you do decide to take on added risk, you have to be that much more confident about your reasons for buying that stock. High beta stocks are useful to bring you outsize gains if you're right about a particular industry or market trend, but you shouldn't rely solely on them to get you to your financial goals.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of and has options positions on 3D Systems. Motley Fool newsletter services recommend 3D Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.