Setting your financial risk

The Beta coefficient helps manage stock portfolio risk

By Jean-Luc Burlone

Economic Analysis

The latest US economic data is quite positive and has sustained consumers’ and businesses’ sentiment of confidence towards the economic context. First quarter results from S&P 500 enterprises have beaten estimates, world growth has strengthened according to the IMF and bond yields have declined — it seems that the recent financial markets euphoria was justified.

However, despite last quarter economic growth being reasonably robust, the sustainability of the current American economy remains in doubt. The level of economic growth is at odds with the low level of unemployment and the low rate of inflation. The old reliable Philip Curve, that describes the inverse relationship between rates of unemployment and inflation, is now broken. Bizarre as well, is the high level of uncertainty that is not reflected in financial markets, where volatility remains, surprisingly, at an all time low.

… the sustainability of the current American economy remains in doubt. The level of economic growth is at odds with the low level of unemployment and the low rate of inflation.

Uncertainty is fuelled notably by the lack of available labour and capital that are the needed resources to sustain the level of economic growth promised by the White House and expected by investors. On top of which, the cost of protectionist measures and the high level of indebtedness are equally ignored by markets.

Financial markets are leading indicators of economic activities and they are creators of wealth as well. The correlation between bull markets and consumers’ spending is positive and robust. Such a reciprocal causality, however, can be reversed by unexpected news.

Financial Strategy

In this awkward environment, prudent investors can set their potential lost to a certain degree. A simple approach is to 1) decide the level of acceptable lost and 2) estimate the volatility of financial assets by calculating the Beta coefficient, i.e. by how much the assets’ value will be changed by a 1% change in the market. For example, if the Beta coefficient is 1.5 and the market corrects by 10%, the financial assets will mark a 15% decline.

‘In this awkward environment, prudent investors can set their potential lost to a certain degree.’

The investor must then reconcile the acceptable lost with the expected lost that can be estimated by multiplying the Beta coefficient by the percentage of the correction and the probability of its occurrence. Concretely from our example above with a probability of 80% that the correction of 10% will occur, with get: 1.5 * 0.10 * 0.80 = 0,12 or a 12% loss ($96,000 on a $800,000 portfolio).

Read Jean-Luc Burlone’s previous article Populism and Technology.

Image: Yahoo via StockPholio.com