What are high beta stocks? Advantages and disadvantages of investing in one

Pranati Deva
Updated: 13 Dec 2021, 12:10 PM IST
TL;DR.

High beta stocks are basically high-risk high reward stocks. So should you invest in one? Let’s decode the risks involved in such stocks and do they outweigh the potential.

High beta stocks are stocks that have a high level of volatility but a better growth potential as well.

High beta stocks are stocks that have a high level of volatility but a better growth potential as well.

High beta stocks are stocks that have a high level of volatility but a better growth potential as well. Unlike defensive stocks, these are not safe stocks that give stable returns despite market performance. These stocks are more volatile than the benchmark market indices and hence are recommended only for investors with a high-risk appetite.

How are they identified?

Such stocks are identified by their beta coefficient. Stocks with a beta coefficient higher than 1 are categorized as high beta stocks.

Let's now find out what is a beta coefficient.

It is the measure of volatility or risk of a stock in comparison to the overall market. This is a common tool to analyse stocks with investors with more experience and a better understanding of market fundamentals.

Mostly midcap and smallcap stocks have been seen to have higher beta coefficients. A beta of 1 indicates that the stock performance is in line with the market. Anything less than 1 shows that the stock is less volatile than the market, while more than 1 shows a more volatile stock.

While stocks with a lower beta have less risk they also have smaller growth potential.

Characteristics

Generally, high beta companies provide goods and services that are in high demand in the economy which leads to better revenue and profits. In the case of midcap and smallcap stocks, lower market capitalization and stock price give them a great opportunity to increase their mcap and thereby its stock value as the firm performs better. Since there is a chance for a higher return on stock price, there is an equal chance of a steep decline depending on market conditions.

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Understanding high beta stocks

Who should invest?

Such stocks are mostly recommended for investors with high wealth creation goals and are looking to invest in high-potential companies. However, these investors must also be ready to take the necessary risk that comes with it.

In the case of a bear market, such stocks can witness an even steeper fall than the broader markets and investors will have to bear the significant loss as market performance impacts the performance of high beta stocks as well.

So experienced investors with a diverse portfolio are apt for investing in high beta stocks since they know when to book profits or hold to ensure minimum risk exposure. They also have other assets to trim their losses in case of volatility.

Other than market conditions, the company's fundamentals, management, balance sheet, revenues will also have an impact on its stock performance. Hence analysts must research well before investing. Apart from this local as well as global events will have a strong impact on the markets and hence the stock and must be considered during investment.

Advantages

1) The biggest advantage of a high beta stock is high returns. When markets are on a high, high beta stocks perform better than the broader markets also. Even a small gain in stock markets can lead to a significant rally in high beta stocks thereby increasing investor returns.

2) High beta stocks also provide a hedge against inflation. This is because they generally generate returns higher than the country's inflation rate. Hence, the value of one's total investment will rise and even in case of an increase in inflation, the purchasing power will not be affected.

Key Disadvantages

1) High risk is the main drawback of investing in a high beta stock. Since these stocks are very volatile, even a small decline in indices could lead to a massive loss in such stocks.

2) Beta coefficient calculation is more accurate for short-term investment rather than long-term ones since it is impossible to know what events are in store globally as well as on the domestic front. Similarly for the firm, one cannot predict its future performance or management issues. So if the beta coefficient is the only parameter considered before investing, while the value of the stock market may continue to rise, the stock may not perform equally well due to internal issues.

Investors continue to choose to invest in high beta shares for wealth accumulation despite the associated risks. While stocks with a beta over 1 are likely to perform better than the benchmark indices given strong company fundamentals and management. However, to mitigate risks one must do proper research and analysis and see how high beta stocks fit in your portfolio.

First Published: 13 Dec 2021, 12:10 PM IST
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