Stock markets are characteristically volatile. But many stocks exhibit remarkable stability. Some, on the contrary, run high on volatility. They are greatly affected by events surrounding them and can be risky. Typically, stocks that run high on volatility are called high beta stocks. But what does beta mean? Are all stocks volatile? Do blue-chip stocks also display high volatility?

Let us find out!

The article covers:

What is beta?

Beta is a mathematical term that in stock markets indicates the volatility of the stock. Beta measures the stock movement as compared to the market index. 

Market beta is always 1. Stock beta is variable, and it depends upon the financial metrics. Whether the stock beta is high or low depends on the market performance too. 

If the stock beta is higher than 1, the stock is considered a high-beta stock. When the stock beta is lower than 1, it is considered a low-beta stock. 

High beta stocks 

The listed companies that have a beta coefficient of more than 1 are termed to be high beta stocks. Stocks that have high beta have the potential to generate exponential wealth, however, such stocks have high risk as well. Investors with extra capital and suitable risk appetite may allocate funds in high-beta stocks to attempt fetching hefty returns. 

Companies that fall in small-to-mid cap criteria usually have a high beta because they react faster to market news (stock becomes volatile) owing to their smaller market capitalization.

Let us understand the relation between beta and volatility with an example. Consider, company X has a beta of 2.05, and company Y has a beta of 1.05. Both these companies are from the same industry. The market beta is the beta of the index that is constant and is taken at 1. 

If the market crashes by 5%, then company X will correct by approximately 10.25% and company Y will correct by 5.5%. Company X with high beta is highly volatile as compared to company Y. 

Generally, seasoned investors, swing traders, and positional traders invest or trade in high beta stocks as a strategy. Even experienced investors who are comfortable with the market volatility generally put in place risk management measures. 

Advantages of high beta stocks

High yields 

High beta stocks are known for outperforming the markets if chosen carefully and timed well. These stocks provide high returns to the investors when the entire market is in an uptrend. Even a slight increase in the index gives a massive push to high beta stocks. 

Best hedge against inflation 

High beta stocks tend to perform well over time, which makes them potentially a good hedge against inflation. Investors can take advantage of high volatility at the right time to trade and make profits from the same. 

Limitations of high beta stocks 

Risk involved is high 

Since the volatility of the stock is high, the risk of losing capital is also high. During a market downswing, high beta stocks fall at a faster rate. A minor fluctuation in the index can lead to the outflow of funds from these stocks.

Market risk 

Beta is calculated based on past data. It does not guarantee the same price movement in the future. For instance, if a company presently borrows debt that is higher than the equity, it will increase the beta of the company (as the debt/equity ratio increases). 

Now, if the company is unable to pay its debts on time, the exposure the investors have to the equity of such a company puts their portfolio at risk. In such a scenario, the creditors of the company may overpower the shareholders, thus risking investor funds. This is why relying solely on coefficient beta is not a feasible option. Investors need to look for other market indicators and fundamentals of the company before making any investment. 

Conclusion 

Beta refers to the measure of volatility and high beta stocks are stocks that experience a significant amount of volatility compared with benchmark indices such as the Nifty or Sensex.  Stock prices of companies with a beta of more than one have the potential to increase at a higher pace as compared to the market indices. The reverse also holds true and hence an investor needs to be extremely careful while investing in such stocks. Understand your risk appetite, research the markets and companies and only then plan for investing.

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Ayushi Mishra

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