To understand how to build a low-beta portfolio, you'll first need to understand how to apply beta to your stock analysis. In this article, you'll learn how to measure beta correctly, use it effectively and identify a low-beta stock for your portfolio.
Understanding beta
Beta measures the relative volatility of an asset or security against a different one (or basket of different securities). To find a stock's beta, you must first have a baseline for comparing it. One of the more common examples is using the S&P 500 as a baseline and comparing individual stocks based on how much more (or less) volatile they are than the overall index.
Beta is a crucial metric in the capital asset pricing model (CAPM) because it allows investment managers to measure the risk of an asset compared to the portfolio they're running. Low-beta stocks have less volatility in their returns than high beta stocks, so managers can weigh their positions based on the amount of risk any particular asset adds to the overall portfolio.
Individual investors can also use beta to determine how much risk any particular stock will add to their 401(k) account, IRA or taxable brokerage account.
Beta values and what they mean
When determining beta, investors start with a baseline of 1. This baseline is often the S&P 500, but it doesn't need to be. You can use beta to measure the volatility of a particular stock within a sector, like comparing the price movement of Tesla Inc. NASDAQ: TSLA to the rest of the tech sector using the Technology Select Sector SPDR Fund NYSEARCA: XLK.
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Greater than 1
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More volatile than the market
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1
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Equal volatility to the market
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Less than 1
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Less volatile than the market
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A stock with a beta of 1.25 will have 25% more price volatility than the baseline market or index. On the other hand, a stock with a beta of 0.75 is 25% less volatile than the baseline, which is what investors looking for low-beta stocks want to see.
Occasionally, you may see a beta value of zero, which means the asset does not correlate with the market being measured. A beta below zero means a negative correlation. Still, stocks with a beta of zero or lower are often microcaps, levered ETFs or other securities designed to be volatile and ultra-risky.
Characteristics of low-beta stocks
What does low-beta mean for a stock? Stocks with a beta lower than 1 (but higher than 0) help reduce volatility in a portfolio, making them ideal securities for risk-sensitive or time-sensitive investors. Low-beta stocks reduce risk because the returns are less volatile, but over a long time frame, high-beta stocks tend to outperform their low-beta brethren.
However, securing the highest possible returns isn't the goal of every investor, and low-beta stocks reduce risk while still providing the possibility of upside.
How can you find good low-beta stocks? Well, for starters, look at the beta coefficient! You can find the figure for beta in the lower right-hand corner of every MarketBeat stock page. With the S&P 500 as a baseline, here's some data on a low-beta favorite: Costco Wholesale Corp. NASDAQ: COST.
Low-beta stocks tend to be found in defensive market sectors since these companies often have products or services with inelastic demand. Costco sells numerous consumer staples products and its club membership business model guarantees repeat customers. Some of the sectors where you can find low-beta companies include:
Low-beta stocks tend to do better during bear markets and recessions since demand for their business doesn't fluctuate. Regardless of the economy, people need food, electricity and medical care, so low-beta companies are good bets to preserve capital during downturns.
Low-beta stock example
One stock sector filled with low-beta stocks is the utilities sector, so let's use one of the oldest and biggest utilities for our example: Duke Energy Corp. NYSE: DUK.
Duke Energy has provided electrical utilities to people and businesses for over 100 years. The company operates mainly in the southeastern United States and has three divisions: electric, gas and renewables. While utilities like Duke Energy are certainly incentivized to turn a profit, they're also heavily regulated and must follow specific operating guidelines (such as guaranteeing service in unprofitable areas).
Duke Energy has a beta of 0.48, meaning it's less than half as volatile as the S&P 500. Companies like Duke often pay high dividends to make up for the lack of stock price appreciation, but the chart above shows the risks involved with lowbeta stocks. While Duke Energy investors likely don't lose sleep over the thought of insolvency, the stock has vastly underperformed the S&P 500 over the last five years.
Advantages of investing in low -beta stocks
Savers nearing retirement who still want the advantages of owning equities without the massive downside risk can optimize low-beta stock portfolios. Some of the benefits of investing in low-beta stocks include the following:
- Stability: Stocks with minimal volatility prevent massive swings in portfolios and can provide a zone of safety during bear markets or economic downturns.
- Risk reduction: Investors with short time horizons can't wait out extended bear markets. A 20% market decline usually represents a buying opportunity when the timeframe is measured in decades. But if you plan to retire within the next five years, a bear market could devastate your long-term plans if there's too much risk in your portfolio.
- Income: Low-beta stocks are often older established companies, including some Dividend Aristocrats and Dividend Kings. Dividend-paying stocks can provide consistent income without much volatility.
Strategies for identifying low-beta stocks
The definition of a low-beta stock can vary depending on the portfolio's risk tolerance. For some investors, a stock with a 0.9 beta compared to the S&P 500 might still be too volatile for comfort.
First, you must identify the baseline of your portfolio. If you have a portfolio of 10 stocks, it's likely much more volatile than the S&P 500, so using the 500-stock index as the baseline of 1 will produce inaccurate figures. Using the CAPM to calculate the alpha and beta of your portfolio can allow you to contrast stocks against the volatility of your holdings, not the overall market.
The actual formula for beta goes as follows:
- B = covariance (asset returns/market returns) ÷ variance (market returns)
In this scenario, market returns can be the S&P 500 or your portfolio. Using the returns of a particular asset compared to the overall portfolio returns allows investors to gauge the risk the asset adds to the mix.
If you have a portfolio that matches the return volatility of the S&P 500, you don't need to use your own calculations. MarketBeat’s low-beta stock screener allows you to compare low-beta stocks based on data like P/E ratio, market sector, market cap and volume.
Risks and considerations
Risk isn't something that can be removed or destroyed by adding low-beta stocks to your portfolio. What does low-beta mean in stocks in terms of risk? The volatility of the returns is reduced, not that the portfolio can't lose value. Additionally, investing in low-beta stocks has risks that aren't normally considered when looking for alpha. Here are some considerations low-beta stock investors must debate when building their portfolios:
- Fear of missing out (FOMO): Nothing does more to drive an investor crazy than seeing their neighbor make higher returns. Investing in a low-beta portfolio often means eschewing the high-volatility stocks that produce some of the market's biggest winners. Seeing outsized returns in other market areas might tempt investors to add higher beta stocks to their portfolios right before a downturn. You must be okay with underperforming during bull markets to benefit from low-beta stocks. After all, what's the point of risk management if you ignore it because your neighbors are richer?
- Backward-looking: You can calculate beta by comparing the historical price data of an asset to the price of the overall market. But these calculations are all performed with data from the past and as we all know, past performance doesn't always predict future performance. New companies mature and stabilize over time, which often means yesterday's high-beta stocks are today's low-beta blue chips.
- Not a one-size-fits-all approach: Lower volatility might be suitable for older investors looking to reduce risk, but these approaches are often the result of long-term financial planning. Would low-beta stocks still be good investments for day and swing traders? Of course not! Different trading styles require different types of assets and short-term traders depend on volatility to profit from price swings. Assess your own goals and investment objectives before building a low-beta portfolio; it may not be in your best interest once you run the numbers.
Low-beta stocks offer security but limit the upside of your portfolio
Low-beta stocks are appealing because they can remove volatility from a portfolio without sacrificing the upside potential, but just because risk is transformed doesn't mean it's eliminated. High alpha low-beta stocks are the rarest of finds since low volatility often coincides with lower expected future returns. While low-beta stocks can be great to hold when markets are in turmoil, a portfolio filled with consumer staples and utility stocks will probably underperform a tech portfolio during good times.
What is a low-beta stock? An investment that isn't for everyone! Low-beta stocks aren't ideal for young investors just starting to stack their retirement accounts since they could provide lower-than-average returns over a long period.
But if you're nearing retirement age and want to soften the blow a future bear market could make on your nest egg, low-beta stocks can be the steady foundation. As always, it's up to the individual investor to decide. Be sure to consult with your advisor if you want to take some risk off the table by adding low-beta stocks to your portfolio.
FAQs
Here are a few commonly asked questions about beta in terms of stock research and analysis:
What is a good beta for a stock?
The answer depends on your risk tolerance and investment goals. If you have a substantial risk appetite, a beta of 1.5 might be ideal. But if you're a risk-averse investor, a beta of 1.5 might be terrifying compared to a beta of 0.5.
Which sectors have the lowest beta?
The lowest beta sectors tend to be defensive industries like utilities, healthcare, consumer staples, communication services and energy. These sectors all have inelastic demand for their products and services, so they tend to get hit less violently during corrections, bear markets and recessions.
What does a stock beta of 0.5 mean?
A stock with a beta of 0.5 would be considered low beta since it is only 50% as volatile as the overall market or index. But you also must consider the baseline index; using the Nasdaq 100 ETF instead of the S&P 500 will produce different results when calculating beta coefficients.
Low-beta stocks tend to outperform during corrections and bear markets but can also lag major indices during booms and bull markets. You'll need to determine the right mix based on your personal risk tolerance and investment goals.
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