Good morning & happy Monday!
“We are in the regret business. If you buy and it goes down, you regret buying. If you buy and it goes up, you regret not buying more.”
– David Lundgren, I’m not sure who this is but I love the quote 😊
So, my last Monday morning memo in February was around the technical investment analytical tool of standard deviation. I’ve tried to control myself and not jump into another technical conversation too soon, but today’s the day 😊. I hope you are as excited as I am! 😉
Today I would like to discuss the investment component known as beta.
Beta is a measure of how similar investments are to each other … what their correlation is to each other. It’s a risk measurement tool as it tracks the volatility of an investment.
The S&P 500 is generally the benchmark for beta.
If you owned the S&P 500 index exactly, that would have a beta of 1.00 … perfect correlation. If the S&P 500 were up 1.5%, you would be up 1.5%. If the S&P 500 were down 1.5%, you would be down 1.5%.
Let’s say you had an investment that was ½ in the S&P 500 and ½ in cash, that investment would have a beta of roughly 0.50, meaning that it correlates to the S&P 500 by 50%. In this example, if the S&P 500 was up 1% this investment would be up by 0.5%. Alternatively, if the S&P 500 were down by 1%, you would be down 0.5%. This example shows a less volatile investment than the S&P 500, thus it will have a lower beta.
This can go in the other direction too. Let’s say you have an investment that is more aggressive than the S&P 500, you could have a beta of 1.25, which means that is portfolio correlates with the S&P 500 index by 25% more than the index. If the S&P 500 was up 1% this investment would be up by 1.25%. Alternatively, if the S&P 500 were down by 1%, you would be down 1.25%. Here the investment is more volatile than the S&P 500.
Beta can even be negative. If an investment has a -1.00 that means that if the S&P 500 is up by 1% that investment is down by 1%. Same vice verses, the S&P 500 is down by 1%, this investment is up by 1%. An extreme example like this virtually never happens in the real world, but just want to explain the concept.
Higher beta = more volatile. Lower beta = less volatile.
Beta above 1 or below -1 is highly volatile. Beta around 0.5 or 0.6 is significantly less volatile.
It’s important to note that this beta measurement is for a certain period of time (example: 1 year). Day-to-day or week-to-week the beta might vary from its annual average.
So, when it comes to beta what do we as investors want? Well, that depends.
If you are a fairly conservative investor we are generally going to seek out investments that have a relatively low beta, targeting a beta of around 0.6 or so for many of the investments. If you are a swing for the fences kind of investor we will actively be seeking investments with fairly high beta, hovering around 1 or even 1.1.
Now, this is not going to be every investment in your portfolio, different funds in your portfolio have different objectives. For example, for a balanced investor we might have 25% of the portfolio in investments with high beta (around 1.00), 25% with a relatively high beta (around 0.85 or so), 25% in lower beta holdings (maybe around 0.65), and 25% outside the stock market in bonds. I’m massively oversimplifying this, but I hope this makes sense.
In portfolio construction we are huge proponents of diversification, which is a whole other topic that I’ll address in more detail another time, which means that we have all sorts of different investments that have different objectives. Not every one of these investments perfectly work every year.
For example, in 2022 real estate was the worst performing asset class we held in our portfolios. Real estate has a relatively low beta, meaning it does not have a high correlation to the stock market, so even though it did poorly in 2022 we recognize the value it brought to the overall portfolio from a diversification and risk metrics standpoint. Real estate could do fairly well even if the stock market does poorly, so we want to own a small portion of the portfolio in real estate. It did not work in 2022, but we believe there will be other years where it works exceptionally well.
We position different assets with different objectives. This is true for asset classes, fund families, and specific fund selection.
Ok, I’ll end there, I know that’s a lot to digest. I hope this makes sense. One of my objectives as your financial planner is to take complex financial topics and try to make them a bit more understandable. I want to arm you with knowledge. Not sure if I was successful in this memo, but I hope it helped make a complex concept just a little more understandable.
Thanks for reading, thank you for trusting us as your financial team, thank you for allowing us to serve you.
Make it a great week ahead!