The most important investment decision people make is where to sock away their money.
So how much do you squirrel away in:
- Cash equivalent, which could be cash, money markets, cashable GICs, and high interest savings accounts
- Fixed income, such as GICs, term deposits, bonds or coupons
- Or equities
The second most important decision relates to the types of equities to buy.
Risk could be defined as the possibility of losing money. And all equities have a degree of risk.
You only have to look at the TSX/S&P Composite Index this year to see that 229 of the 244 stocks comprising the Index are in negative territory year to date. Some stocks have declined much more than others year-to-date, highlighting that not all equities are of the same risk level. Beta is a financial term associated with equity investing and measuring risk. More specifically it relates to the volatility of a stock in relation to a specific market. For purposes of this column we will use the TSX/S&P Composite Index, which comprises 244 of Canada’s largest companies. The Index has a beta of 1.0.
Before we get into the details about beta, most of us should agree that penny stocks, small-capitalized companies, and those with no analyst coverage generally have more investment risk than large established companies with a history of paying dividends (also known as “blue chips”).
What some investors might not know is that many large established companies that are household names have more risk and volatility associated with them than the general market.
Mutual funds and exchange-traded funds that carefully track the Index will have a beta close to 1.0. Beta is more important for people investing in individual stocks. Individual stocks can be compared to each other using beta. Ranking stocks according to how much they deviate from the Index is an easy exercise. A stock that has more volatility than the market over time has a beta above 1.0. A stock that is less volatile than the market has a beta of less than 1.0. If a stock has a beta below 1.0 then it will have less dramatic movements than the market.
Let’s use a stock with a beta of .5 as an example. If the Index were to increase 20 per cent then we would anticipate this stock to increase ten per cent. What if the market declines 20 per cent? A stock with a beta of .5 would historically decline by 10 per cent, even though the index has declined by 20 per cent.
Let’s use a stock with a beta of 1.6 as another example. If the Index were to increase 20 per cent then we would anticipate this stock to increase 32 per cent. If the market declines 20 per cent we would anticipate this stock to decrease 32 per cent.
To illustrate we will look at two portfolios, A and B, each comprised of 20 stocks taken from the Index. The beta for the portfolio is the weighted average of the betas for the individual stocks. We have assumed that each position is equally weighted. Portfolio A will have the 20 stocks with the lowest beta on the Index. Portfolio B will have the 20 stocks with the highest beta on the Index.
- Portfolio A (lower risk and lower reward): The sum of the twenty lowest beta stocks on the Index is 10.46. If we divide this number by 20 we have an average beta of .52. Based on historical changes in values and a 10 per cent change in the Index we can estimate possible outcomes. If the Index increases 20 per cent, the historical upside return would be approximately 10.4 per cent. If the Index declines 20 per cent, the historical loss on this portfolio would be approximately 10.4 per cent.
- Portfolio B (higher risk and higher reward): The sum of the 20 highest beta stocks on the Index is 35.62. If we divide this number by 20 we have an average beta of 1.78. Based on historical changes in values and a 10 per cent change in the Index we can estimate the possible outcomes. If the Index increases 20 per cent, the historical upside return would be approximately 35.6 per cent. If the Index declines 20 per cent, the historical loss on this portfolio would be approximately loss of 35.6 per cent.
The above shows a rough illustration of how a portfolio can be structured to reduce risk on the equity side. Reducing risk in a portfolio reduces the potential for large losses and large gains. Portfolio B has significantly more risk than Portfolio A, and it also has the potential for greater gains and losses.
Beta should not be entirely relied upon because of its historical basis of measurement. If new information becomes available this is not immediately reflected in the beta. As we have seen during the past year, often at times the markets become irrational and fundamentals mean little in the short run. Some investors feeling bullish may sell the lower beta names and buy higher beta names if they feel the markets are at a low and conditions are improving. Beta is not an indicator of how a stock will perform, only a reflection of what has happened.
It is an interesting exercise to determine the overall beta of your portfolio. Despite its shortcomings, beta provides one way to measure individual stocks amongst each other. If you have a portfolio weighted towards high beta names, you will likely see more ups and downs.