Trading High-Beta Stocks: Risk vs. Reward

Growth investors and investors with high-risk tolerance may be interested in high-growth, high-beta stocks. High-beta stocks can generate high returns but also have significant downside risks when markets fall. Understanding beta and its uses can be important for growth investors seeking to identify the best-performing stocks.

Understanding Beta

Beta is a statistical measure of a stock's relative volatility to the broader market, typically the S&P 500, where it can measure risk. A stock's beta is found through regression analysis that infers the correlation in price changes in the stock to the S&P 500. A beta of 1.0 indicates that a stock’s volatility is parallel to the market and will often move in tandem with the index and at the same magnitudes.

A beta above 1.0 means the stock will have greater volatility than the market, and a beta less than 1.0 indicates lower volatility. Volatility is usually an indicator of risk, and higher betas mean higher risk, while lower betas mean lower risk. Stocks with higher betas may gain more in upward markets but lose more in downward markets.

Covariance is the measure of a stock’s return relative to that of the market. Variance is the measure of how the market moves relative to its mean.

Investing in High-Beta Stocks

High-beta stocks can be great investments in bull markets since they are expected to outperform the S&P 500 but require a great deal of active management because of their market sensitivity. These are highly volatile and risky investments in isolation. In a bear market reversal, stocks can be expected to lose the most. High-beta stocks are generally not long-term buy-and-hold investments.

For growth in a portfolio, an investor will likely choose stocks with a beta above 1, providing a greater chance of a higher return for assuming the higher risk of losing value when the market goes down. Investors can hedge this volatility by adding a variety of stocks close to 1, depending on their risk tolerance. Investors who predict the market to move downward will also look at stocks with negative betas.

Examples of High-Beta Stocks

As of February 2023, these three stocks have betas around 2.0 and are members of the S&P 500 index.

Advanced Micro Devices (AMD)

AMD is a semiconductor company that makes chipsets and microchips, competing with Intel and Qualcomm. As of February 2023, its market cap was $126.57 billion. The company is riskier than most S&P 500 stocks, with a beta of 1.98.

NVIDIA Corporation (NVDA)

Nvidia Corporation is an American multinational technology company founded in 1993, incorporated in Delaware, and based in Santa Clara, California. As of February 2023, its market cap was $532.99 billion, and its beta was 1.79.

ETSY, Inc. (ETSY)

Etsy is the global marketplace for unique and creative goods, connecting buyers and sellers from nearly every country. As of February 2023, Etsy's market cap was $16.3 billion and had a beta of 1.86.

Limitations and Risks of High-Beta Stocks

An investor will need more information than beta to assess whether a stock belongs in the portfolio. Beta does not account for trends or news events that may impact a stock. Stocks with high betas are more volatile than the overall market, and beta does not predict the direction of a stock's price or consider the company's strength.

The Bottom Line

High-beta stocks require active management. They are also often small to mid-cap stocks maturing with significant volatility around new announcements and trends. Investing in high-growth, high-beta stocks come with high risks, so investors often seek to balance them with lower-risk portfolio holdings and cash liquidity.