Playing Defense: The Case for "Low-Beta" Stocks

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Playing Defense: The Case for "Low-Beta" Stocks
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
October 1, 2008

Reprinted from the September 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Experienced investors know that the stock market doesn't go straight up, yet we often begin to lose faith in equity investing when stock prices fall without quickly rebounding. This response is natural. Psychologists estimate that the emotional pain that people feel from losses is usually two to three times greater than the pleasure they receive from gains. Apparently, the human tendency to flee from risk is a basic survival instinct that's hardwired into our brains. Unfortunately, following this instinct when investing can cost investors dearly, as the fear of losing money may lead us to abandon stocks at just the wrong time.

The risk inherent in equity investing can never be completely eliminated. But recently, Schwab researchers identified a simple but effective strategy that historically has lowered equity portfolio risk without lowering portfolio returns proportionally. Perhaps more important, this risk-reduction strategy can help investors avoid self-defeating behavior such as lowering portfolio allocations to stocks after market declines. Think about it as the investment equivalent of a strategy used by many sports teams: "The best offense is a strong defense." In the world of equity investing, our analogous strategy is to consider owning stocks with low "beta" values.

What is beta?
I'm sure you've noticed that the prices of some stocks tend to bounce around more than others. Back in the 1970s, researchers developed a statistic called "beta" to measure how the investment return of any asset moved vis-à-vis the overall market. While there are several ways to calculate beta, probably the most common method is to compare a stock's monthly returns to the S& P 500® Index's returns over the previous five-year period.

With the beta of the S&P 500 Index set at 1.0, stocks that have tended to swing more than the market have betas above 1.0, while stocks that have fluctuated less than the market have betas below 1.0. All things being equal (which they rarely are), a portfolio of stocks with betas averaging 0.80 would tend to rise 8% in a period when the S&P 500 rose 10%, and to fall 8% in a period during which the S&P 500 fell 10%.

Beta: Theory versus reality
The early high priests of modern portfolio theory argued that betas completely defined a stock's "systematic risk"—that portion of equity risk that cannot be eliminated by building a well-diversified portfolio of many stocks. Therefore, a diversified portfolio's expected return relative to the overall market should be proportional to that portfolio's beta. In theory, an investor who held a low-beta portfolio could expect to experience less risk than the market, but the cost would be a lower long-term return than market averages—there is no free lunch.

Well, it didn't take long for investors to realize that beta didn't work as advertised. The measure did a decent job of forecasting the expected risk levels of diversified portfolios, but not their expected returns. The tendency for high-beta portfolios to deliver weak long-term returns with well-above-average risk is well-documented. Some recent studies have found that portfolios of less-volatile stocks (using risk measures other than beta) have delivered higher returns than market averages—a fascinating research finding we've attempted to incorporate into Schwab Equity Ratings.

A tool for the risk-averse
After observing that beta hasn't lived up to the promise of modern portfolio theorists, most investors seem to have dismissed beta as an outdated tool. I believe this is a big mistake. Ironically, the fact that stock returns are not proportional to beta values can make beta an extremely useful tool for risk-averse individual investors.

To illustrate, we went back to 1986 and, each month, split the Schwab Equity Rating universe of the 3,200 largest-market-cap stocks into halves based on each stock's beta. We then measured the average equal-weighted returns of the low- and high-beta portfolios over the 22½ years through June 2008. As you can see in the "Low-Beta Stocks: Less Return, Much Less Risk" table below, the low-beta portfolio produced a lower average annual return than the high-beta one: 13.3% versus 15.2%. But the low-beta portfolio's returns were significantly less volatile (as measured by the standard deviation of annual returns).

Low-Beta Stocks: Less Return, Much Less Risk

In other words, the returns of the low-beta portfolio were smoother over time. As a result, the low-beta portfolio's risk-adjusted returns (return ÷ volatility) were significantly higher. Also, the low-beta portfolio performed much better when stock market returns were negative. Resiliency in down markets is highly desirable, because that's when investors are most likely to be tempted to abandon their long-term equity strategies.

Looking more closely at down-market performance, we compared returns from the low- and high-beta portfolios during the five biggest down-market quarters since 1986. Both portfolios had negative returns during those periods. However, the low-beta portfolio tended to hold up much better than the high-beta portfolio during large market drops (see the "Low-Beta Stocks: A Down-Market Cushion" table below). So we'd expect a low-beta portfolio not only to better protect investor wealth during periods of extreme market stress, but by dampening losses, to also reduce investor temptation to panic.

Why betas vary
There are two primary reasons why betas vary across different stocks. First, some types of businesses are inherently less risky than others. Intuitively, it should be no surprise that stocks of larger, more established companies typically have lower betas than smaller firms, or that slow-growth utility stocks tend to have lower betas than tech stocks with high and uncertain growth expectations.

Second, the prospects of some businesses are more closely tied to stock market and economic fluctuations than others. For example, brokerage stocks generally have higher betas than life insurance stocks because brokerage firm fortunes are more dependent on stock market performance. Restaurant stocks have higher betas than pharmaceutical stocks because nonessential consumer spending is more sensitive to changing economic conditions than spending on necessities (see the table below).

Stock Betas by Sector

However, a low beta doesn't always mean low volatility. For instance, gold-mining stocks typically have low betas because their prices tend to vary with precious metal prices rather than stock market movements, but mining stocks tend to be highly volatile.

About 70% of stocks have betas between 0.5 and 2.0. Most stocks' betas are pretty steady through time as long as the underlying companies don't evolve too quickly or run into extreme business stress. So a stock with an extremely low or high beta will generally moderate back toward more typical beta values over time.

How to find attractive low-beta stocks
Stock betas tend to be uncorrelated to most commonly used stock-selection criteria, with two major exceptions: Low-beta stocks tend to have above-average dividend yields and below-average earnings growth forecasts. This means that if you employ strategies that emphasize strong fundamentals, cheap equity valuation or high momentum, you can find stocks to your liking that also have below-average betas. With a little more research, you can also find low-beta stocks with nice earnings growth rates. But remember, low-beta investing will tend to put the very fastest-growing or most speculative stocks off-limits—not a bad compromise (see Don't Overpay Today for Growth Tomorrow).

If you'd like help selecting low-beta stocks, Schwab Equity Ratings can be a great tool for clients. In historical simulations back to 1986, low-beta stocks rated A or B provided returns similar to high-beta stocks rated A or B, but with much less volatility. While such performance was hypothetical and based on historical data, this research suggests that Schwab Equity Ratings could be a powerful, time-saving research tool for investors hoping to match or beat market returns over a complete market cycle while enjoying the smoother ride a low-beta portfolio can provide.

If a low-beta equity strategy appeals to you, consider using our Stock Screener (clients can find it under the Stocks tab on Quotes & Research). We suggest you start your search on stocks with betas between 0.0 and 1.0. After that, ignore beta and use criteria such as Schwab Equity Ratings to identify stocks to purchase. And, of course, create a widely diversified portfolio with at least 40 stocks and sector weightings that generally match the overall market (see Constructing a Diversified Stock Portfolio).

Important Disclosures

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio.

Results from tests using Schwab Equity Ratings are based on use of historical model performance results that have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual investment performance or trading. No representation is being made that any investor will or is likely to achieve profits or losses similar to those shown. The results presented are for illustrative purposes only and should not and cannot be viewed as an indicator of future performance, as an indicator of the returns a Schwab client would have realized or will realize in relying on Schwab Equity Ratings, or as an indicator of how individual Schwab Equity Ratings are performing or will perform in the future.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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