The stock market’s rally has been impressive. The major indexes are now up about 40 percent from their recent lows, give or take a few percentage points. And for anyone who scooped up more speculative shares on weakness, the profits could be even higher.
Personally, I don’t ever recommend purchasing shares of companies with shoddy business models, consistently unprofitable operations, poor track records of caring about their shareholders, etc.
But I realize that many investors did buy these kinds of stocks as aggressive ways to play a rebounding market. And that’s why I wanted to make a particular point in today’s column to warn you about holding on to these companies in your portfolio.
Reason: I believe the easy gains have already been made, and the losses on any downside move could be very sharp and swift, erasing any profits that have piled up.
In Fact, the Very Definition of “High-Beta” Stocks
Is That They Make Outsized Moves BOTH Ways!
Typically speaking, the less stable a company is fundamentally, the greater the swings in its share price. That makes sense when you think about it …
After all, a firm that has been around for 100 years … posted solid sales and earnings gains … and built a stable of well-known brands is far more likely to survive economic and market cycles than a start-up company running on venture capital fumes.
The measure of an individual stock’s volatility relative to the broad market is called its “beta.” Here’s how it works …
Analysts assume the market (such as the S&P 500 index) has a beta of 1 and cash has a beta of 0.
Thus, if a particular stock’s beta is above 1, the shares are likely to experience swings greater than those of the market. Conversely, a stock with a beta under 1 will probably swing less than its comparable index and is closer to having your investments sitting in cash.
Let me give you an example: If XYZ stock has a beta of 0.5, it should move half as much as the S&P 500. In other words, if the S&P 500 loses 10 percent, XYZ should fall 5 percent. Ditto for up moves — if the market rises 10 percent, the stock should gain 5 percent. Meanwhile, under the same market conditions, a stock with a beta of 4 would be expected to go up or down 40 percent!
For this reason, many investors equate beta with “risk.” And that is largely accurate, though beta is simply a reflection of a stock’s past moves.
