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Investor Clinic

The ups and downs of volatility Add to ...

Ever notice that stock market forecasters never predict "periods of exceptional price stability" or "long stretches of sober and rational decision making by investors"?

No, like weathermen with a sadistic streak, they like to warn that markets will be volatile for the foreseeable future. Perhaps that's understandable. After all, investors have endured their share of hurricane-force winds for the past few years.

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So today, in response to some reader questions, Investor Clinic will take a closer look at volatility. Hang on to your hats, folks, we're going into the eye of the storm.

When I look up a stock quote on Globeinvestor.com, I see something called "beta." What does it mean? -L.K.

Beta is a measure of risk or volatility - specifically, how volatile a stock is relative to the market. It's a useful measure because it gives you a sense of what you're dealing with excitement-wise.

A stock with a beta of 1 exhibits volatility similar to the overall market. A beta of more than 1 indicates greater volatility than the market. And a beta of less than 1 indicates less relative volatility.

Different sectors display different beta characteristics.

For instance, utilities - which are regulated and generate predictable cash flows - typically have a low beta. Electric and gas utility Fortis Inc. has a beta of just 0.15, meaning it's less than one-sixth as volatile as the market. Other low-beta sectors include consumer staples, telecoms and health care.

At the other end of the volatility spectrum are cyclical companies such as Teck Resources Ltd., which has a beta of 3.53. Some tech companies are also notoriously volatile: Research In Motion Ltd.'s beta is 1.72.

Beta "tells you a lot about what you're exposed to," said Myles Zyblock, chief institutional strategist at RBC Dominion Securities. "If you're a stock picker and you think you have a great name for whatever reason, and it also has a high beta, you might have some embedded risk there that you're not aware of."

Beta is also useful for identifying market trends. For example, when markets began their powerful rebound in March, 2009, high-beta stocks led the recovery. Not coincidentally, these same high-beta stocks had been hit hardest during the financial crisis.

As useful as beta is, it doesn't provide a complete picture of a stock's risk. "There's all sorts of risk, financial risk, economic risk, market risk," Mr. Zyblock said. Beta only tells you about the effects of market risk - that is, how sensitive a stock is to market changes.

To get a full appreciation of a stock's risk profile, you need to look at company-specific factors as well - the firm's balance sheet, earnings and competitive position, among other things.

Nor is beta a reliable indicator of a stock's returns, Oppenheimer strategists Brian Belski and Nicholas Roccanova said in a research note.

"Strategies based entirely on beta characteristics are too simplistic, in our view, as stocks in the two highest-beta quartiles have traditionally displayed some of the weakest returns following the end of recessions," they said.

I keep hearing about the VIX. What is it exactly? - G.M.

No, VIX isn't the stuff your mom used to rub on your chest when you had a cold. It's the ticker symbol of the Chicago Board Options Exchange Volatility Index, also know as the "investor fear gauge."

A higher VIX corresponds to expectations of heightened volatility over the next 30 days, while a lower VIX reflects expectations for less volatility. Specifically, the VIX uses S&P 500 stock index option prices to measure near-term expectations for market volatility.

What do options have to do with volatility, you ask? Well, investors use put and call options as a form of insurance for their portfolios. A put option, for example, gives an investor the right to sell a security at a certain price by a certain date, which protects the portfolio's value in the event of a sharp market decline.

When investors are fearing the end of the world, they're willing to pay more for such insurance, so options prices rise, pushing up the VIX. When fear subsides, option prices fall, pushing the VIX back down. It's the "implied volatility" in options prices that the VIX is measuring.

Currently, the VIX sits at about 23, which is about average for the past year. During the sovereign debt crisis last spring, it topped 45. And during the 2008 credit meltdown, it soared to a record of more than 80.

The VIX is more than just a measure of fear. Sophisticated investors buy and sell options and futures on the VIX to speculate or hedge their portfolios. But not everyone is convinced the index has much utility for ordinary investors.

William Bernstein, author of The Investor's Manifesto, said the VIX is actually a coincident indicator of market sentiment, not a forecasting tool.

"It has zero predictive value beyond knowing that there's blood in the streets, and that's always the best time to buy stocks," he said. "But I wouldn't need the VIX to tell me that. All I have to do is read the newspaper and talk to my friends. I mean, when the market goes down 200 or 300 points and it's at the top of the news every day and everybody is worried and all of your friends are selling their stocks, then the VIX is going to be high."

Follow on Twitter: @johnheinzl

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