Posted by Zurich Awes on November 29th, 2018.
In spectacular fashion befitting tech stocks, market darlings Amazon and Alphabet (Google) have both tanked in the last two months, by -22% and -12% respectively. During this same period, the S&P 500 was down by -9%.
But that’s not the important part. (Unless you own these stocks, then, ouch…) Instead, the hidden gem, the insight, is the relationship between their losses.
(Although, that large stake in money market looks pretty good right now.)
Risk and Reward are the two of the most fundamental concepts of investing. Investors want to know how much they could lose in their attempts to gain. But all risk is relative. It’s like that old game show, “Let’s Make a Deal.” Most contestants would risk a few dollars for a chance at some wonderful prize, but as the price went up, and as their winnings mounted, the contestants became more and more reticent to “risk it all for what’s behind door number two.”
Investing is no different. But because risk is relative, in order to calculate the inherent risk of an investment, it needs a benchmark. This can be another investment, a market index or even simply cash. Common benchmarks include long-term treasuries or stock markets indexes like the S&P 500 or the Dow Jones Industrial Average.
Benchmarks are critical because they provide a reference point, a beacon in the investing storm. If your goal is to outperform the S&P 500, including losses, then your benchmark would be the S&P 500. If your goal is to conserve your money, and avoid big losses, then your benchmark would be long term treasuries, or even cash.
If you’re a growth stock, like Amazon or Alphabet (Google), whose sole objective is to make as much money as possible, as quickly as possible, then the S&P 500 is probably a better benchmark, Or even maybe the Nasdaq 100. After all, as a company, you’re trying to woo investors to buy your stock, and a high beta dangles the implication that you could generate higher returns than a common benchmark.
The technical definition of Beta is “a measure of volatility of a security or portfolio in comparison to a benchmark.” In other words, how much one investment will increase or decrease in relation to the performance of another.
Unbeknownst to most non-professional investors, investments are a statistical game. The best investments are those that perform in line with their specific beta, either up or down. If an investment is expected to go up in an up market, and it does, it’s considered to be “in line with its beta.” But, and this is a commonly missed critical fact, this that also means that this same investment is expected to go down in a down market.
For example, Alphabet (Google) has a beta of 1.3 against the S&P 500. This means that the movement of Alphabet (Google) should multiply the S&P 500’s performance by a factor of 1.3. In other words, if the S&P 500 drops by -9%, then Alphabet (Google) should drop by 12%; because 1.3 x -9% = -12%. This is exactly what happened in the last two months.
Now take Amazon, with its beta of 1.95 against the S&P 500. If the S&P 500 drops by 9%, then Amazon should drop by 18%; because 1.95 x -9% = -18%. Of course, Amazon dropped beyond that, by -22%; as betas seek to provide guidance, not absolutes.
One of the critical measures of an investment portfolio is risk tolerance. This can be measured with beta, standard deviation, and a host of other measures. Knowing your beta, can help give you a sense of your best and worst case scenarios against a common benchmark.
If you’re retired, or within five years, have a large, diversified, solid investment portfolio, that needs to produce income for the rest of your life, without being eroded by the long term effects of inflation, then your benchmark is probably treasuries or the broad corporate bond market. This sort of portfolio has a low beta against the S&P 500, which could be as low as 0.2, instead of Alphabet’s (Google) 1.3 beta or Amazon’s 1.95 beta. In other words, a significant move by the stock market would likely have little effect on this portfolio.
But if you’re young, have a young family, a strong income, and are at least 15 years away from retirement, then the S&P 500 is probably a better benchmark. Then maybe you’d want a mix of investments whose beta was in the 1.3 or even 1.5 range. After all, common consensus says that even if the next stock market crash wipes you out, you have plenty of time to rebuild. (I think it’s stupid to accept being wiped out, but hey, that’s just me.)
In my opinion, a better use of beta is to build a portfolio whose beta capitalizes on the current market conditions. In a rising stock market, use a high beta. In a falling stock market, use a low or even a negative beta. Of course, this requires that you know in what type of market you currently find yourself. Do you know?
Maybe now is a good time to find out. Let’s talk.