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How To Use Beta To Lower Investment Risk

February 18th, 2012 Leave a comment Go to comments

Before you start investing in stocks, you very likely put your money in cash or cash-like investments. Making the jump to stock investing requires jumping over a chasm because you are putting your principal at risk because that’s how stocks make you money over cash investments.

Investing in stocks over cash equivalent investments requires a very large mindset change. Stocks can both make and lose money. Because equity investments are priced every trading day, your first impression may be that the market is right and knows something that you don’t know when an investment changes in price. When I first started investing in stocks I made the mistake of trusting the wisdom of the market too much. Sometimes the market is right but many times the market is wrong, especially when you shorten the time horizon.

In 2008, nearly everything went down in price without any real regard for the merits of each individual business. We are now in the first quarter of 2012, and we can see that many companies have come back to not only the same levels as 2008 but even higher! But in this wake are many companies that went out of business or have never recovered (e.g., Bank Of America). The lesson from this cycle is that the market is often times not right in the short term, but rarely wrong in the long term. Over the long term, the issues that come up each day eventually get settled or worked out building a consensus about the company.

How can you insulate yourself from the risk of loss in the stock market? There isn’t any foolproof method except not investing at all. Investing in the stock market doesn’t have to be an either or situation, you can implement strategies to significantly reduce your risk of loss. There is wide ground between ‘safeguarding principal’ and ‘losing your shirt’. One of these strategies is to use a measure called beta.

How To Define Risk

There are different kinds of risks associated with buying stocks. The risk that most investors dread is a bear market which causes extreme loss of investment value. This forces down the value of your investments even if there is little or no reason in many cases for specific companies. If you suffer a loss, particularly larger ones, it becomes harder to get back to even, much less a gain. To quantify this, a drop of 50% (which we experienced in 2009 for the market index), requires a 100% increase just to get back to even.

The best defense against bear markets is to buy investments that don’t drop as much as the bear market. This is not a hard thing, because the volatility measurement called beta offers a means to quantify the potential volatility of an investment.

How Beta Helps You

For low risk investing, beta is your friend. Beta indicates the volatility of an investment relative to the market as a whole. The market itself (the S&P500 index) is assigned a beta of 1 because it is the unit of comparison for everything else. To see beta in action, let’s compare ExxonMobil (XOM) versus the market starting off as an investment in the beginning of 2007. ExxonMobil is a great example, because it’s beta is 0.50, exactly half the implied volatility of the market. This means that you would expect XOM to drop by half the amount of overall market when the bear appears. Here’s the chart:

The bear market of 2008 culminated with an over 50% decline in the stock market. XOM declined less than 15% at the low point of March 2009. Nobody wants a 15% decline but a high quality company like XOM wasn’t in any danger of insolvency. The stock has since come back and is beating the market as well! Buying quality companies with low beta can get you downside protection plus all the upside.

Where To Find Beta

Beta can be found on many financial site’s quote pages for stocks and ETFs. Mutual funds also are quoted with beta on financial web sites for the information sheet that comes with the mutual fund on the manager’s site. Keep in mind that actively traded mutual funds may have a beta that is more of a moving target since the fund manager can change investments more frequently than index or passively managed funds and ETFs. On Google’s financial site you can find beta in the stock quote:

What About ETF Investors?

OK, you may not want to be a stock picker, perhaps you are an ETF or mutual fund investor. Beta works here, too! If you don’t want to invest in individual stocks you can use beta with your ETFs. The market standard, S&P500 index, which is a broad index of 500 high quality mid-capitalization and large-capitalization stocks that by definition has a beta of 1, can be broken down into slices. Each slice has its own volatility measure that differs from the whole. There are many other examples of investing in sectors that offer different volatility characteristics but it is instructive to note the wide divergence of beta within the S&P500 index itself.

ALPS Distributors has created ETFs for different segments and sectors of the S&P500 index. Here are the ETFs, the stock symbol is listed in parentheses.

Segment/Sector Description Beta
Financial (XLF) Financial 1.48
Consumer Discretionary (XLY) Consumer Discretionary/Cyclicals 1.11
Energy (XLE) Energy 1.07
Technology (XLK) Technology 1.02
S&P500 (SPY) Whole Market 1
S&P500 Growth (SPYG) Growth 0.99
S&P500 Value (SDY) Value/Dividend Aristocrats 0.87
Health Care (XLV) Health Care 0.67
Consumer Staples (XLP) Staples/Secular 0.57
Utilities (XLU) Utilities 0.52

This list gives you a good idea on where to start to find investments with low beta. The sector with the lowest beta is the Utilities sector. This is not a big surprise, Utilities are a defensive sector that generally have stable businesses and good dividend yields.

Uncorrelated Investments

Some investments don’t have volatility anywhere near stocks, or even specific stock sectors. These investments are not correlated with stocks because they may not be stocks. These investments can be used to offer an ability to invest in things that are uncorrelated with stocks to provide diversification away from stocks. There are many examples, such as commodities and bonds. The iShares Barclays TIPS Bond Fund, e.g. has a beta of 0.11. Gold, the utiltimate hedge against stocks, has an equally low beta of 0.11 as represented by the Gold ETF (GLD).

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  1. February 18th, 2012 at 09:20 | #1

    Excellent analysis SFI. I find beta very useful when I’m looking into investing in a stock I’m not familiar with. Beta isn’t perfect (think BP), but the best measure there is to gauge volatility.

  2. February 18th, 2012 at 10:06 | #2

    Thanks for stopping by moneycone. Beta won’t help you in a meltdown of a specific company. Most people don’t invest in specific stocks probably for this reason alone, lots of things can happen to a specific company.

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