Beta factors: How they can be used in the current situation

by: Andy George

Ever since the turn of the century, world stock markets have been very volatile. In other words there have been significant movements (up or down) in share prices. This phenomenon has been evidenced by the collapse in recent years of the share prices of the dot com companies (e.g. Yahoo, Amazon etc.) and the sharp falls in the share prices of telecommunication stocks (e.g. British Telecom, Marconi etc.). Yet despite these events there is very little emphasis placed on measuring the volatility of stocks.

The aim of this article is to explain one method of measuring the volatility namely beta factors and how investors can interpret this information. The article aims to state how investors can use beta factor analysis to their advantage when there are political uncertainties affecting markets. Though some stockbroker firms calculate the beta factors of certain stocks quoted in their respective stock exchanges, investors have little access to these figures. In more developed markets many stockbroker firms do have access to beta factors but it is only in recent years that investors have access to this information.

BETA FACTORS:

The beta of an investment is a relative measure of the systematic risk of an investment. In other words it measures the specific risk of the company's shares relative to the market as a whole. In general, the sign of the beta (+/-) indicates whether, on average, the investment's returns move with the market or in the opposite direction to the market. The scale or value of the beta indicates the relative volatility of the particular stock.

A beta of +0.25 for instance, would indicate that on average, the investment's returns move one quarter as much as the markets do in the same direction. If the market rose by 10%, the investment would be expected to rise by 2.5% but on the other hand if the market fell by 10% the investment would be expected to fall by only 2.5%. A beta of -0.1 would indicate that on average, the investment's returns move one tenth as much as the market's do, but in the opposite direction. If the market rose by 10%, the investment would be expected to fall by 1%. Hence we can summarise a number of situations:

If Beta > 1 this means that the investment's returns will move, on average, in the same direction as the market's returns, but to a greater extent.

If Beta = 1 this means that the investment's returns will move, on average, in the same direction as the market's returns, and to the same extent.

If 0 -1, to the same extent if Beta = -1, and to a greater extent if Beta < -1. In practice it is rare to find negative beta stocks since they go against the trend of the market. One possible sector that could consist of negative beta stocks is the gold industry that tends to go against the trend shown by equity markets.

INVESTMENT STRATEGIES:

In world markets, beta factors can have a major influence on the investment strategies of investors. If the analysis is to be believed then in times of a bull market (rising markets) investors should hold stocks with a high positive beta factor since they should outperform the market. A practical example of this was in the late 1990’s concerning the dot com stocks. At this time the bull market has reached its peak and those investors who held dot com companies (that had high positive beta factors) made excess returns and did far better than the relative index performances.

However in times of bear markets (falling markets) then investors should target low beta stocks since they should outperform the market. An example of this can be found in the UK where two low beta FTSE stocks (Tesco and Centrica) outperformed the market in a falling market.

USING BETA FACTORS IN THE PRESENT SITUATION:

The current world political situation is probably the worst it is for many years. World markets are falling at a rapid pace. What does beta factor analysis teach us about an investment strategy in this situation? Firstly, however good a company is it likely that in such circumstances most will encounter falls in their share prices.

However during this time a number of alternative investments that have negative beta factors have appreciated in value. The prime example of this is gold. Over the past twenty years when there was a strong equity bull market, the price of gold has fallen significantly. In addition to this shares in the gold sector have performed badly when compared to equities. However in the past few years it is noticeable that in the political uncertainty that has arisen in the world that the price of gold has shown material gains at a time when equity markets have recorded sharp falls.

Another commodity that has done well is oil that has seen a significant increase in its price per barrel over the past few months. In line with gold, the oil price has suffered over most of the past twenty years (at a time when equity prices were on an increase) and it is only in recent years that the oil price has shown a recovery.

CONCLUSION:

Beta factor analysis is a useful technique that has enabled many international investors to achieve satisfactory returns in the past. If one looks at the trends in world markets then one can see that in a bull market those investors that have followed a selective aggressive portfolio (i.e. including shares with beta factors of over 1 times) have generally outperformed the market.

However the wheel has changed. We are now in the stage of a bear market. The current political uncertainty has made things extremely difficult for investors. Should they get out of world markets since a conflict will almost certainly mean falling equity prices. Or should investors move to alternative investments with negative beta factors such as gold and oil? After all in case of a conflict these commodities will almost certainly rise and will probably go against the trend of equity prices. The answer will very much depend on how the current political situation develops. However investors will do well if they include gold in their investment portfolios.

Disclaimer: No responsibility for loss can be accepted to any person acting or refraining from acting as a result of material in this article.

©2004 by Andy George. All rights reserved

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