If you want to invest your money in a smart way, financial experts have recommended avoiding big, high-growth stocks in favor of value names that aren’t as popular. The basic strategy: identify opportunities while minimizing some risk. But the Chicago-based financial firm Morningstar says there’s a smarter way to make money—beta can help investors identify better stock opportunities during economic uncertainty than value or growth. Let’s break down how this metric measures volatility and when you can use it to invest.
If you’re looking for smart ways to make money, a financial advisor could help you identify good investments for your portfolio.
Why Morningstar Says Investors Should Focus on Stock Volatility
When analyzing investments, many investors look at value investments (undervalued stocks that could gain the most value over time) and growth stocks (those that can outpace competitors by a significant margin).
While comparing value vs. growth stocks could make sense for your portfolio, Morningstar says that right now, with economic uncertainty, it is difficult to determine how the environment could favor either value or growth.
Morningstar recently reported that since the mid-June low point of the bear market (which generally happens when prices fall by at least 20% from a recent high), growth stocks gained 20.3% in two months while value stocks went up by just over a third of that (7.8%) during the same time.
Though the financial firm also said that data from both stocks shows how they broke “relatively even,” with the gap between value and growth narrowing since the most recent market peak on August 16, and value stocks jumping “ahead of growth stocks by 6.8 percentage points.”
Due to this narrowing gap between value and growth stocks, Morningstar said that investors could benefit from a starker contrast between high- and low-beta stocks to find investment opportunities. And specifically, it pointed out that “high-beta stocks are cheap.”
“The overall market is 15% undervalued right now,” said David Sekera, chief U.S. market strategist for Morningstar in the article. “So it’s a good time to shift further into high-beta stocks, to capture extra upside when the market recovers.”
Understanding How Beta Works
Beta is a metric that measures the volatility of a stock. This is usually calculated by comparing stock price changes with the movements of a broader stock market like the S&P 500 over a 12-month period.
Stock markets overall have a beta of one. And the beta for an individual stock is calculated by how far it moves from that benchmark index.
As an example, if a stock has a beta of one, then an investor could assume that its price moves closely with that market. And this could mean that adding it to your portfolio would not take on much risk.
Individual stocks with betas greater than one could indicate higher volatility. But for investors with a greater risk tolerance, this could also show a potential for stronger returns.
As another example, if you buy a stock with a beta of three, then it could be three times as volatile as the overall market. So if the S&P 500 goes up by 10% in a year, you could expect the individual stock price to go up by three times as much (30%) during that time. Though it is important to note that it could also fall by 30% while the overall stock market goes down only by 10%.
For stock with a beta under one, investors could determine that it’s less volatile than the overall market and add it to their portfolios to hedge against risk and diversify investments.
However, you should also note that a beta under one could show that the individual stock moves in an opposite direction from an overall market. And this could indicate that the stock’s price goes up when the market goes down or seesaw the other way when the market goes up.
Finally, betas of zero could also show that individual stocks act independently from overall markets, therefore emphasizing that beta is just one of many factors that you should look at when analyzing an investment.
How Investors Can Use Beta to Make Investments
Morningstar says that high-beta stocks can be found in the cyclical super sector, which is a grouping of industry stocks that are highly-impacted by changes in the economy.
These stocks can shift based on different factors over time, and include energy, consumer cyclical (automative, housing, entertainment and retail), basic materials (mining, metal refining, chemical and forestry products) and tech.
The financial firm says that investors can identify stocks with a low beta to help minimize risk for their portfolios. But also notes that “low-beta investment strategies may miss out on rewards when the market does well.”
For investors with a higher risk tolerance, Morningstar said that “areas of the market with the highest beta are trading at some of the lowest prices.”
As an example, the financial firm referenced its US Consumer Cyclical Sector Index, which carried “an above-market beta of 1.26 as of the end of August, and finished the month at 87% of its aggregated fair value, or a 13% discount.”
Additionally, Morningstar reported that both technology and communication services indexes carried “some of the highest sector-level betas as of August,” which “are also among the most undervalued market sectors, currently at 89% and 65% of their Morningstar analyst-assessed fair value estimates, respectively.”
And for a comparison, the financial firm said that utility stocks ended in August as some of the lowest betas, with the index standing at “8.3% above its aggregate fair value.” Investors with low risk tolerance tend to focus on utility stocks to hedge against economic downturns because of stability and high dividend yields.
Beta can help investors determine how the price of an individual stock could move when compared with an overall market. The financial firm Morningstar points out that during periods of economic uncertainty, when value and growth stocks may be too close, high- and low-beta stocks could help investors identify new investment opportunities. However, you should note that this metric is based on past performances, so it may not account for present and future changes impacting individual stocks. Therefore, it is useful to combine this metric with others in a fuller analysis before making an investment decision.
Investing Tips for Beginners
- A financial advisor could help guide you in making smart investment decisions for your portfolio. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- The best way to protect yourself from risk as an investor is to diversify your assets. SmartAsset’s free calculator can help you figure out the right approach for your portfolio.
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