The Two Faces Of Volatility
Whenever someone asks me about an investment, I always ask them about risk tolerance. What do I mean by that?
Specifically, I want to know how much of a decline in a stock’s value an investor could tolerate before feeling the need to sell the stock. For some people, that number is pretty small. For others, they might let the stock fall all the way to zero and not sell it. (I am in the latter category because I keep my position sizing small, but that’s a topic for another day.)
So, how do you know the risks of a stock when you invest in it?
One of the guidelines we have is a measure called beta.
The beta of a stock is a historical measure of that stock’s daily movements compared to a broader market index, typically the S&P 500. A stock with a beta of less than 1.0 means that its daily moves are on average less than the market index. Stocks with a beta higher than 1.0 historically moves more than the market index. Stocks with a negative beta moves in the opposite direction from the market index.
The main takeaway from beta is that it gives some relative measure of how quickly shares can drop in a down market. If you have a low risk tolerance, for example if you are retiree counting on income from your shares, then stick with low beta sectors.
Following the steep declines in March and subsequent recovery in April and May, I thought it might be worthwhile to review the recent volatility of the various sectors of the S&P 500. For this exercise, I looked at the six-month volatility of the Sector SPDR exchange-traded funds (ETFs).
Volatility During the COVID-19 Selloff
Select Sector SPDRs are targeted ETFs that divide the S&P 500 into 11 sector index funds. These sectors are Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Materials, Real Estate, Technology, and Utilities. The 11 Select Sector SPDRs represent the S&P 500 as a whole.
S&P Sector Beta Covering the Past Six Months
The beta of the S&P 500 is 1.0 by definition. This comparison doesn’t help understand just how large the swings have been over the past three months, but they do show how all sectors moved in relation to the S&P 500.
At the bottom of the scale is the Consumer Staples sector. This makes sense. Even though much of the country experienced stay-at-home orders, we still require consumer staples like food, beverages, and toiletries. This sector held up well in the face of the declines and subsequent recovery.
The Health Care sector is a bit more surprising. As the COVID-19 pandemic escalated, hospitals began canceling elective procedures to help prevent the spread of the virus and to devote more resources to COVID-19 patients. But these actions are financially stressful for hospitals. While it is true that health care is extremely critical during this pandemic, it isn’t necessarily true that the sector is making big profits.
However, we have relied heavily on the Communication Services and Technology sectors as much of the country worked from home. It also makes sense that these two sectors have held up well.
On the high end of the volatility scale were the Energy and Real Estate sectors. The market battered both sectors as the crisis worsened. Oil demand plunged as people stayed home, and commercial real estate came under tremendous financial stress as tenants saw their revenues plummet.
The one sector that seems out of place here is the Utility sector. Historically, it is one of the lowest-volatility sectors. So what happened? It actually held up well initially, but when businesses began to close there were fears that profits would fall.
But the performance of the Utility sector this year has been very much in line with the overall S&P 500. In fact, the year-to-date performance of the Utility Sector SPDR (XLU) is within 1% of the S&P 500. But beta measures daily moves, and the daily moves of the utility sector were greater than those of the S&P 500 during this time.
From a longer-term perspective, however, utilities are in fact the least volatile sector. The 5-year beta for the Utility sector is 0.41, followed by Consumer Staples at 0.59 and Real Estate at 0.74.
The Upside of Volatility
But volatility isn’t all bad.
For example, the Energy sector took a deep dive in early March. But since then it has been the top performer among all sectors. From the bottom on March 23, the Energy Select Sector SPDR (XLE) has returned over 64%, which is 20% more than the second-best performing sector.
You can make a lot of money in high-volatility sectors, but it’s a high-risk, high-reward play. You have to be certain that this is the kind of investor you are before engaging in that kind of risk. If you aren’t, stick to the lower end of the volatility scale.
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