How to Find the Right Investment Opportunities by Using Beta Scores

Do you like volatility? Some investors see volatile prices as an opportunity to score big gains. Others prefer sticking with the less exciting but less dangerous alternative: stable stocks with predictable returns.

The beta value of a stock is one popular way to measure volatility. Let's figure out what it actually means -- and how you can use this simple number to find the right kind of investment opportunities for your own portfolio.

In short, beta values come from comparing price swings in your stock to a reference portfolio. That's typically the S&P 500, but you can also build betas referencing the Dow Jones Industrial Average the Russell 3000, the Japanese Nikkei index, or even your own portfolio. Yes, you can compare the volatility of your own holdings to the volatility of your total portfolio. The values used in the rest of this article are five-year beta values from S&P Capital IQ, which naturally measures things against the S&P 500.

High values indicate that a stock tends to move faster than the chosen index, whether it's moving up or down. A reading of 1.0 means that your stock might as well be the index because the two tend to move in tandem. When the beta is close to zero, there's little (if any) correlation between the index's moves and your chosen stock's performance -- and a large negative number points to something that moves in the opposite direction of your portfolio or market index.

Still clear as mud? Let's look at some examples from the Dow and beyond.

The highest five-year beta on the Dow right now belongs to Bank of America , at 2.4. The megabank pretty much defined the 2008 crash, whose five-year anniversary passes later this year. Share prices often soar in reaction to strong economic data and plummet based on poor broad-market news. B of A has its financial fingers in virtually every infrastructural sector in America, and it sits on shaky fundamentals. Economic recovery is a make-or-break trend for this company. Investors in these risky yet promising stocks are both nervous and excitable for good reason. That's why Bank of America shares fly higher and crash harder than other stocks -- yet still pace the broader market on most days.

Microsoft's 0.97 beta is as close to the ideal 1.0 as you'll get on the Dow. The software giant does have its mood swings on occasion, but it still acts as a pretty good proxy for market trackers like the Dow or the S&P 500. Redmond wins some and loses some, but it hasn't hit any real home runs since Windows XP in 2001, and it has avoided catastrophes since Windows Vista, now adorned by six years of graying neckbeard. Zoom out to 10 years, and Microsoft's beta grows larger, but it's a brutally mediocre performer in this five-year window.

On the lowest end of the Dow spectrum, Wal-Mart Stores scores a 0.34. Yes, the world's largest retailer feels it when the average American's pocketbook tightens its belt a few notches. But Wal-Mart softens that blow by being a leader in low-cost staples. That's why market crashes hurt a little bit less in Bentonville, Ark. On the flip side, Wal-Mart loses customers when the larger economy comes roaring back, which dampens the upside of nationwide recoveries. Wal-Mart's stock reflects these effects in its very low beta score.

None of the 30 Dow stocks provides good examples of the two remaining extreme-beta situations. You have to step down to someone like Sequenom , a small-cap diagnostics and genetic analysis company, to find a stock entirely disconnected from the market's larger swings. That stock gets a minuscule beta score of just 0.05.

Negative scores tend to belong to popular market hedges. Think gold stocks or bearish ETF vehicles like the Direxion Daily Large Cap Bear 3x Shares. These things are basically designed to move in the opposite direction of the stock market -- and swiftly so in the case of highly leveraged ETFs. The Direxion ETF I just mentioned, for example, boasts a beta of -2.8, according to Google Finance. I'm not 100% sure that Google measures its beta values the same way that Capital IQ and Yahoo! Finance do, but you get the drift anyhow.

To summarize:

  • A very high beta shows that Bank of America is a high-risk, high-reward stock.

  • A shockingly average beta presents Microsoft as a stable performer with market-average risk and rewards.

  • Wal-Mart's low beta points to softer landings and slower take-offs than your average stock.

  • Sequenom lets you invest in one stock without caring much what the Dow or the S&P 500 are doing.

  • Gold or bearish ETF trackers with negative betas can give you an effective hedge against the larger market.

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Editor's note: A previous version of this article incorrectly referred to Sequenom as a cancer drug researcher. The Fool regrets the error.

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