Measure Investment Risk With One Simple Indicator

The market is still a tad jumpy here in October as concerns mount that the tepid European recovery is losing steam. Small cap and growth stocks are finally showing their true nature again – bouncing around far more than the broad market.
This type of action often leads investors to wish they had a better sense of how far their stocks will move as compared to the broad market.
Thankfully, there is a statistic designed to measure investment risk. It’s called “beta”.
If you ever want to get a better sense of how a stock is likely to move relative to the market, remember to check out the stock’s beta. Beta measures how closely a stock is correlated with the market. A beta of 1 means the stock tends to move the same amount as the broad market (the S&P 500).
A beta over 1 means the stock should move more than the broad market. And the degree of relative movement is measured by the difference between a stock’s beta and 1. For instance, a beta of 1.2 implies that a stock would move 20% more than the market. We tend to measure beta over a period of months, not just one day, so it smoothes out daily volatility.
Take a quick look at Yahoo! Finance and you’ll see that most small cap and technology stocks have betas well above 1. For instance Netflix (NASDAQ:NFLX) has a beta of 1.3 and Splunk (NASDAQ:SPLK) has a beta of 1.5.
This makes sense, because these stocks tend to have higher return potential than the S&P 500. They’ll move further, faster, and investors must accept more volatility to compensate for greater upside potential.
Beta is directly related to market volatility, which has been on the rise in recent weeks.
This 2-year chart of the S&P 500 shows what I mean. The blue line is the 50-day moving average (DMA) and the red line is the 200 DMA. As you can see we haven’t broken the 200 DMA since November of 2012.
I’ve also included a chart of the market’s volatility as measured by the VIX index. As you can see, this index is approaching 20, a level that we last hit in January of this year when the market corrected by 6%. Currently we’re at around a 4% correction.
A VIX reading of 20 or higher has happened four times in the last two years. This would be the fifth if it gets there – so it’s significant, but not altogether rare. And it doesn’t signal impending doom, it simply means that market volatility is relatively high, and high beta stocks are moving around a lot more than any broad market index.
When the market gets this volatile it’s helpful to have some sense of the beta of the stocks you own. That knowledge will help calm your nerves considerably. And help you maintain conviction in the higher beta stocks that you own that are likely to outperform the S&P 500 after volatility subsides again.

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