Investors, whether individual investors with small portfolios or institutional investors with billions of dollars to invest, should always pay attention to volatility. Minimizing volatility long-term is ultimately the determining factor to creating a strong performing portfolio. Many investors, including myself, use beta as a way of determining how volatile a stock can be. In this article, I explain why that may not be the best strategy for small investors.
Beta is defined as the change in a security's market value with respect to a change in the value of a market portfolio. The number tends to be consistent throughout different industries. For example, highly leveraged, high risk companies like banks have stocks with high betas and companies with very predictable operations, like reinsurance companies, have stocks with low betas.
Financial institutions tend to use beta as a measure of volatility for stock investing because their overall goal is to beat the competition- whose average return ultimately comes out to be around the market return. "The market" can be an excuse for a financial institution to have a bad quarter.
For individual investors, the goal is more to generate a return to expand wealth. Although individual investors should attempt to take advantage of bull markets to gain good returns, it is still important for them to make sure they are protected against a bear market.
A great example of a stock that demonstrates my high beta vs. high volatility argument is Groupon (GRPN). Groupon's market beta, going back to its IPO, is 1.02, which makes it appear to be a stock that fluctuates similarly to the market. However, we all know that Groupon shares have been on a roller coaster ride since the beginning. In fact, the annualized standard deviation for Groupon shares is 87.3% since its IPO. During this same time, the annualized standard deviation for the S&P 500 is 20.0%. The average daily change for Groupon has been an unbelievable 3.29% compared to the S&P 500's daily average change of 0.73%.
The point is, for smaller investors with fewer holdings in a portfolio, stock volatility can become a more important, and often overlooked, factor in making investment decisions. From a mathematical perspective, the large discrepancies between beta and volatility come from stocks that have very little covariance with the market. This happens with companies like Groupon, whose business activities vary greatly with what the average company does. It is more commonly seen in alternative asset classes. For example, Annaly Capital Management (NLY), an mREIT, has a beta of only 0.31, but its annualized standard deviation since November 4th, 2011 is 15.06%, which is much more volatile that what its beta would make you think.
The same is true with Treasury bond ETFs and any asset class whose cash flows are not generally reflected in "the market". Although these alternative asset classes should still be considered by small investors, it is important to look at the volatility, and not the beta, when making investment decisions.
My actionable advice for individual investors is to look at the volatility of securities you invest in as much as you look at expected return, valuation, and dividend yields. Overloading your portfolio with volatility can happen easily and can potentially bankrupt someone who doesn't have the time or portfolio value to strongly diversify assets. Considering variance can be done by other means than manually calculating standard deviation and covariance for every stock in your portfolio. Looking at 52 week highs and lows and day to day stock performance and establishing a gauge for what is good and what is bad should be enough to avoid overloading a portfolio with aggressive securities. With a strong understanding of the fundamentals, any investor should be able to properly manage their portfolio's volatility to meet their investing needs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.