Often an investor may want to know what the historical volatility of a stocks price is before investing. In this way, investors can either take advantage of a high volatility stock or stay away from it. There are several ways to measure a stock’s price volatility.
One measure is the alpha coefficient. This is a measure of the projected rate of change of a stock’s price independent of market-related factors. If all other factors are equal and the market remains at the same level for a year, the price of a stock with an alpha of 1.5 could be expected to increase by 50 percent. This increase would be based solely on the strength of the company’s earnings, projections for increased sales, introduction of new products and other indications of the company’s health and well-being. In short, the alpha is based in internal fundamentals of a company.
The beta coefficient quantifies the degree to which a stock’s price changes in comparison to a change in the market. Some stocks are more volatile than the market, some move closely with the market and some are less volatile than the market as a whole. Beta is measured numerically. Stocks with a beta of one move with the market. For example, if the Standard & Poor’s 500 index moves up 10 percent. Stocks with a beta greater than one (such as 1.5) move more than the market. If the Standard & Poor’s 500 index moves up 10 percent, the stock price will be likely to increase by approximately 15 percent. Stocks with a beta less than one (such as .75) move less than the market. If the Standard & Poor’s 100 index moves up 10 percent, the stock price will be likely to increase by approximately 7.5 percent.
If the beta coefficient is exactly 1,the stock’s return will probably move exactly with the market. If it is less than 1 it will move less than the market moves and if it is greater than 1, it will move more than the market moves.
In general, the greater the beta coefficient, the more risk associated with the security. High beta coefficients may indicate greater profits during rising market, but they also mean greater potential losses during market downturns. When the market rises by 10 percent, a stock with a beta of 2.0 is expected to rise by 20 percent on the average (or fall by 20 percent when the market is down 10 percent). Therefore, investors who are risk averse should avoid stocks with high beta coefficients (often called aggressive stocks). Instead, they should consider stocks with low betas. Stocks with low betas are considered defensive and more appropriate for risk-conscious investors who understand that they are trading off some potential return for lower market risk.
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Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.