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A strategy based on Beta to beat the market

Publication Date: 30 Jul 2018 - By Stephanie Bedard-Chateauneuf By Stephanie Bedard-Chateauneuf
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Equity Fundamental Equity USA

The S&P 500 index has historically returned about 10% on average annually. If you don’t think you can beat the market over a long period of time by buying stocks, then it’s a good idea to buy an exchange traded fund (ETF) that replicates the whole market. But it’s possible to beat the market over the long-term by buying the right stocks at the right time. I suggest a strategy based on beta that can help you beat the market over many years. 

What is beta

A stock’s beta is a measure of a stock’s volatility, that is to say, how a stock’s price moves relative to the market’s movements. A beta of 1 means that the stock is moving with the market. A stock that has a beta higher than 1 (high-beta stock) moves more than the market, while a stock that has a beta lower than 1 (low-beta stock) moves less than the market.

For example, a stock with a beta of 2 will move twice as much as the S&P 500 moves. If the S&P 500 gains 10%, the stock with a beta of 2 will gain 10 x 2 = 20%. On the other hand, if the S&P drops by 10%, the stock will drop by 20%. So, if the overall market is rising, the stock should rise more; if the overall market drops, the stock should plunge more. That means the stock has a higher potential return but for a higher risk than the market. The opposite is true for a low-beta stock.

When to buy high-beta and low-beta stocks

To profit from the beta strategy, you first need to determine in which direction the market is headed. If you think the broader market is heading higher, then a high-beta stock should outperform. For instance, Spectrum Pharmaceuticals Inc. (NASDAQ:SPPI), a small-cap stock in the health sector, should outperform in a bull market because it has a beta of 2.6. This has been the case during the last years because the market has been rising. While the S&P 500 is up about 7% year-to-date, Spectrum Pharmaceuticals’ stock has gained 17%, beating the market by 10%.

But if you think we are about to enter a bear market, like the one we had in 2008, you should rather buy low-beta stocks like Colgate-Palmolive Company (NYCE:CL), a large consumer goods company that has a beta of only 0.6.

This stock will generally fall less than the market when the latter is plunging because it is less volatile, giving you downside protection in a bear market. Indeed, in 2008, Colgate-Palmolive fell by only 10% while the S&P 500 dropped 37%. On the other hand, Spectrum Pharmaceuticals plunged more than the market, falling 45%. But in a bull market like the one we are in since 2008, Colgate-Palmolive underperforms the market; it’s even down 11% year-to-date.

Bottom line

As bull markets last longer than bear markets, it is important that you have a great amount of money invested in high-beta stocks if you want to beat the market. But it is also essential that you hold some shares in low-beta stocks to give your portfolio some protection during market downturns.

To be successful with the beta strategy, you also need to determine the market’s direction first before buying a stock. The strategy has more chances to be profitable if you buy high-beta stocks just before a bull market, and low-beta stocks before a bear market.

Disclosure:

I have no positions in any of the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

Stephanie Bedard-Chateauneuf

 

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London, United Kingdom

info@reachx.co
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