It goes
without saying that investing in growth stocks can be “risky” or “volatile”,
but how does one measure these terms? Such a measure would immensely help an
investor quantify his risk to determine whether or not he could stomach the
swings of a particular growth stock. Luckily for you, there is such a tool, and
it is known as “beta”. It will allow you to sleep at night and still own
aggressive growth stocks.
Beta expresses the volatility of a security in
relation to the market as a whole.
The
beta of any individual security is measured against the market and is therefore
viewed in comparison to 1.
Essentially,
it is a measure of sensitivity to market changes by a stock. This means that
the stock can be assessed for risk in comparison to the market and therefore
the national economy.
If
a security has a beta of exactly 1, the moves of the market, both up and down,
are reflected exactly by the security. By definition, this is a very rare occurrence.
It is, however, most likely to occur amongst the very largest companies since
any move in price that they have has the biggest impact on the index. Equally,
the index moving can have a big impact on their quoted price.
Should
a company have a beta of more than 1, the price of the security is more
volatile than the market. The movements of the company price exaggerate those
of the market. Therefore, if the market rises, the company share price will
rise faster. If the market falls, the share price will fall faster.
Less
than 1 tells us that the price of a security moves less than the market but in
the same overall direction. The security is therefore more stable in price than
the overall market.
All
this means that beta can provide a relative measure of risk compared to an
index, a sector or a benchmark. It is calculated using monthly price movements
over the preceding 36 months.
Astute
readers will recognize that this offers the potential - in theory at least if
not always in practice - to balance a portfolio by holding companies that
behave in opposing ways to those of the stock market as a whole.
Even
more astute readers will recognize a further truth... Measurements such as beta
enable the risk to be balanced in a portfolio, but that is a focus on capital
preservation. For many investors - both private and professional - the aim is
to do much more than preserve capital. Therefore, being able to select stocks
with growth potential might be more important than risk mitigation.
As
is rightly asked, if I manage your portfolio correctly and outperform our
chosen index but the fund still loses money, is that acceptable?
This
is, after all, one of the central precepts of the fund management industry -
benchmarking against a relevant index. But, if the index falls by 20% in a
calendar year and a fund that is compared against it only falls
by 15% in the same time period, is that fund really a success? Losing money is
still losing money, no matter how things compare when using beta to help
analyse returns.
It
is possibly for these reasons that the hedge fund industry has seen such rapid
growth.Wealthy Clients that understood that they wanted to make an actual profit every year preferred the
concept of alpha and an absolute return.
Another
possibly interesting angle for readers to think about is the way in which terms
such as volatility and risk impact their entire finances and net worth, rather
than just their stock portfolio. This is a topic which has been explored in
some depth by author Robert Frank in his book The High-Beta Rich, where he looks
at the impact that borrowing has had on the finances of America's richest
people.
He
certainly finds some interesting correlations between a high value 'paper' net
worth (probably held in stocks, or perhaps the ownership of one business) and
the risks taken on when the owners of these assets borrow large amounts of
money against these assets to live the lifestyle that they feel they deserve.
The risk is obviously that the value of their asset could fall leaving them
with large debts and minimal security. If nothing else, such a book makes the
reader think carefully about the impact of borrowing to fund lifestyle needs.
