This risk measurement tool allows us to quantify the relative risk of an asset compared to another asset.
In practice the S&P index is often set as BETA 1, while cash does not change its nominal value and thus posts a BETA 0.

A negative BETA would be an asset with a negative correlation to the overall asset markets. This could be shares of a company making money by sorting out bankruptcies, but the sector making more money when everybody else is in trouble must be very tiny. If the BETA-factor is too high e.g. 20, the underlying business would not be sustainable and loose all its value if the general markets decline just by 5 percent. So for all practical purposes BETA is seen as a positive number in the single digits.

Limitations
This risk measurement concept has, with all its practicality, also some shortcomings. If you want to use this Concept in your risk management you need to understand the following fact:

• The BETA-Coefficient for each asset is calculated from historical data with regression analysis. This means that the number shows us what happened in the past. But things may change, and a reasonable history is not a guarantee for the future. A business could take a load of new debt to finance a new uncertain project. It would now be much more risky.
• The risk position of a whole sector may change for political or technological reasons.
  Compared to the energy sector which depends much on the overall economic activity, the agricultural sector has a quite stable demand picture. But nowadays we observe that fossil energy reaches at times a price level high enough to substitute petrol with agricultural commodities. This changes certainly the risk behavior of agricultural assets.
• Another problem for risk measurement with the BETA-Factor is hidden in the tail risk. As long as the overall market remains inside the usual ranges, the relationship between the risks of two assets or asset classes may be reasonably linear. But come unexpected circumstance, assets considered conservative and low risk (e.g. public debt instruments) may turn out to be high risk, no longer hold by pension funds but traded by hedge funds.

Conclusion
The BETA factor as risk measurement tool is very useful to manage your portfolio. Using them you need to cover your exposure to extreme market changes by setting automatic stop losses and using spreads whenever trading derivates. And you have to reevaluate and rebalance your portfolio in relatively short time intervals.

You could buy

1. Stocks
2. Bonds
3. Real estate
4. Natural resources
5. Gold

Your savings will end up in these asset classes, even if you delegate their management e.g. by buying an insurance policy, which will promise you a monthly payment after you retire. They also have to invest the funds you sent them to get a return on top of the principal.

The use of asset classes can helps you to manage them properly and to balance the risks you take. This is done by grouping together financial assets with similar characteristics. The sorting criteria have to with the nature of the assets as well as with their behavior in certain risk scenarios. I want to give you here a short run down of the most commonly used categories for financial assets:

Equity
You find in here investments giving you ownership rights of a business. Examples are shares traded at a stock exchange or stakes in a partnership etc. Ownership means the right to influence business decisions e.g. through voting rights, and the right to receive a share of the business profits. There is no guarantee on any future payment. If the business does not earn a profit, the shareholder will be left empty handed. And if a business goes bankrupt, equity in this business has lost any value whatsoever.

Debt
Debt means in this context that you lend somebody some money against the promise of a sequence of return payments to give you back the principal and the agreed interest. In this case you have a legal right to receive these return payments. The debtor cannot say “I did not make a profit this year, so I cannot pay you anything.” If a business or a private person cannot meet the payment obligations coming from a lending contract, the result will be bankruptcy. In this case a court will supervise how the remaining assets of the business will be divided up between the people to whom the debtor has payment obligations. The debt holder does not have a right to influence business decisions as long as the debtor fulfills his contractual obligations

Real Estate
The real estate asset class comprises ownership rights on land and buildings on that land. If you hold real estate assets not for your own use, but to generate a cash flow, you may look at it as a special form of equity. But the difference between a real estate investment and a typical equity investment is the fact that you do not have clear information about the value of a piece of land or a building every day. It may take several months to sell it, and you will know the price only at the end of the sales process. In contrast to that, you can sell shares of a big company with a few mouse clicks; you will have price quotes at least on a daily basis

Commodities
If you invest in commodities, you buy a quantity of clearly defined items, mostly natural resources. Most commonly traded are metals like copper, silver, aluminum, agricultural commodities like corn, lumber and wheat, or minerals for energy supplies like crude oil or coal. Commodities are items you own, whereas equities are rights you own. They have a well defined market price at any time, and a use value. Another important characteristic of commodities is that you need to store them if you own them. To store them implies costs.

Gold
Gold is in a commodity, which at times takes on the role of money. The reason for the monetary role of gold is the limited supply and the fact, that gold is easy to store. It will not be damaged by water, light, heat, frost. It won’t break if fallen down. You can hide it in the soil of your garden, and if you dig it out after 100 years it will still be the same amount of the same gold.

These are in five generic asset classes. All of them have their strengths and their risks. While real estate may provide a safe and enjoyable place to stay in normal times, and debt a steady cash flow, the asset classes of gold and equities may provide better protection from inflation. Commodities may protect against political risks and may rise in times of crisis and war, but there is a cost involved in holding them. The cost of holding commodities can be greatly reduced by the use of futures and options instead of holding the underlying assets themselves.

Fundamental Analysis
Let us start with fundamental analysis of a financial market. It is quite simple: a fundamental analyst observes the development of supply and demand in the market he follows and the factors that determine both. If you take as an example the oil market, a fundamental analyst would consider events like:

• New oil field explorations
• Problems like the current deepwater horizon oil spill.
• Movements of oil and gasoline stock levels.
• Usage level of refinery capacity
• Development of alternative energies
• Overall economic activity

The fundamental analyst combines all these factors into a single picture, and will end up with an opinion whether supply and demand are in an equilibrium, and remain in an equilibrium, or whether there will be an excess supply the foreseeable future or excess demand.
As a last step he evaluates the current market price level, asking whether in this example oil is priced fairly.

Technical Analysis
The fundamental approach sounds fair enough. But I have seen more than one big company going belly up just a few weeks before the market did, what they had forecast. But by then it was already too late. This is where the other mode of analysis comes into play: technical or chart analysis. Technical analysts use information about recent market behavior, like price movements, tends, trading volumes, volatility etc. to get an idea what the market might do next. The idea is that it is almost always possible to see the picture generated by fundamental analysis as a glass half full or a glass half empty. A technical analyst tries to figure out, how the market participants in sum react on the fundamental market information. They might ignore bad news for a long time, and then suddenly panic. Or they might become excited about good news, only to discard it a few days later. Policy makers and spin doctors may want to influence the market perception of the fundamentals. Technical analysts do not try to forecast the actions of spin doctors, but the charts may very well give a hint, whether a PR stunt may have a real impact at a given point of time. The main thing to understand: Technical analysts use mathematics and statistics. But in truth they try to measure and forecast market perception of fact on the ground. Fundamental analysts on the other hand try to establish and understand the facts of supply and demand itself.

Use Fundamental and Technical Analysis as a Pair
Considering it all, fundamental and technical analysis relate to each other like a brother and a sister. They are quite different, and the fundamental analyst does not understand or even respect the technical analysts all the time – and vice versa. But to really understand a market and to make money with trading, you need both: a firm grasp of supply and demand conditions, and a thorough understanding of the current market perception of these facts, as evidenced by market behavior and measured by technical analysts.

The Risk
After defining the value of an asset, the next question is: What is the meaning of the term “risk” in the context of financial assets? Modern trading platforms allow us to know the current price of any liquid asset with precision. But do we know tomorrow’s price of the same asset? We do not know. The price can change, most probably will change. But we do not know in which direction. This insecurity about the future price of an asset is called the asset’s financial risk. Risk is a complicated concept having at least three dimensions:

1. The magnitude of the price change
2. The probability that this change will actually happen
3. The timing

Risks have also a value and price. But the price of a risk can be negative. In our day-to-day thinking, we associate the term “risk” with an undesired possibility. If we would profit from the same possible event, we would use the term “hope” instead of “risk.” This distinction between “hope” and “risk” relates solely to our position relating to the possible event. It is possible and in the financial world standard, that one party’s “risk” is for the counterpart “hope”. A high price for wheat may be the farmer’s hope, but the baker’s risk.
For this discussion, we use the term risk for the probability and magnitude of a possible change regardless of the question whether we desire or fear that specific outcome. We do not differentiate between “hope” and “risk”.

Trading Risk
As the same event can be good for one person and at the same time very bad for another person, it makes sense to trade risks. Both could share the pain and the gain and improve their ability to plan their businesses.
Financial institutions developed tools to separate financial assets and risks form one another. One very simple example would be a contract between the farmer and the bakery spelling out that the bakery will buy a certain quantity of wheat in autumn from the farmer for a specified price. This price could be a little higher than the current price, thus giving the farmer an extra profit. But it would protect the bakery from the danger of a huge price rise making the bread too expensive for the bakery`s customers. This generic future contract would be a good deal for both sides.

Futures and Options
The contracts used to separate financial assets and risks are called derivate contracts. The example between the farmer and the bakery is a future contract, in which they agree to a sale of a certain quantity of a certain asset for a predetermined price at a specified time in the future. This future contract is binding for both sides, the farmer must sell and the bakery must buy.
Another generic form of a derivate contract is an option. The option comes in two forms:

The Call
The farmer could sell a call to the bakery. In this case the bakery would pay the farmer for the right to buy a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the farmer. The buyer of the option, the bakery, exercises its right if he chooses. Otherwise the contract will expire.

The Put
The bakery could sell a put option to the farmer. In this case the farmer would pay the bakery for the right to sell a certain quantity of wheat in autumn for a specified price, the “strike price”.
This contract is legally binding for the seller of the option, the bakery. The buyer of the option, the farmer, exercises its right if he chooses. Otherwise the contract will expire. Please note, that in this case the buyer of the option is the seller of the underlying asset.

Hedges
If you combine two risks, the sum of the two original risks may be bigger than the combined risk. Think about an area with frequent hurricanes: It could make sense to bet on a profit of insurance companies and to bet at the same time on a profit of building companies. In a strong hurricane season, the insurance would suffer and the builder would profit. In a weak hurricane season, the insurance company would profit and the builder would lose. If you buy insurance company shares and shares of the home builder, you can smooth out the difference between years with strong hurricanes and years with weak hurricanes. If you use options or futures on the shares of both companies, you may even be able to profit financially from the hurricane threat.

Warning
Be careful. Derivate contracts are very powerful tools with a high leverage. Because they allow you to treat financial assets and risks separately, you can also accumulate dangerous risks, if you mishandle them. The result can be very and painful and dangerous. Never enter a contract, if you do not understand all implications completely.

ETFs Caught in the Storm

Last week the markets hit rough weather. One of the attractions of ETFs is that they are excange-traded, which means they can be bought and sold all day long, just like stocks. Last Thursday, however, that feature proved itself to be a risk factor as well.
When circuit breakers brought NYSE trading in some key stocks to a halt, their prices plunged on various electronic systems. And ETFs that held those stocks dropped as well.
The “market makers” who are supposed to provide liquidity — didn’t. And the fear quickly spread to all corners of the equity markets. Stocks and ETFs traded — and some orders were filled — at discounts of 50 percent or even 90 percent to where they had been just minutes earlier!
For instance, the iShares Russell 1000 Growth (IWF) is a popular ETF that typically trades more than three million shares a day …
Last Thursday at 2:40 pm Eastern time, it was trading at $49.70, which at the moment like most of the market was down about 3 percent. Over the next five minutes it fell to $48.29, another 3 percent drop. A minute later, at 2:46, it was at $44.23.

Then the bottom dropped out …

At 2:47 IWF traded at $19.98. Prices continued to plunge during the next 30 seconds. Many trades went through at 15 cents and one at a penny!
When the minute was up, IWF was again trading at $47.43. A minute later it was back to 10 cents. Stability returned as it climbed from $17.69 to $36.88 to $49.65. By 3:00 IWF was back above $49, completing its round trip in about 16 minutes.
(Note: Trades below $19.88 were cancelled for IWF. But thousands of shares traded at a 40 percent to 60 percent discount to prices prevailing just minutes earlier.)

Politicians wasted no time jumping on the bully pulpit.
If your reaction is “this makes no sense,” join the club. Indeed it doesn’t make sense — but it happened. One thing we can always rely on, however, is a swift and senseless reaction from Washington …
Even before the dust settled, people on Capitol Hill were shoving each other out of the way to get their share of the headlines. Regulators sniffed and threatened investigations.
I’m totally in favor of appropriate market safeguards. But I’m against overreaction that makes the problem even worse — and I fear that’s what we are going to get.

News Flash: Markets Go Both Ways

Here is a hard truth the politicians and regulators don’t want to admit: Markets are volatile. They go up, they go down. Everyone has an even chance to profit if the playing field is level.

Look at what just happened last week …

Somebody bought all those stocks and ETFs that traded at such ridiculously low prices. They were smart to do so. They deserve to profit — but they aren’t going to. Why? Because the exchanges decided to cancel many of the “outlier” trades.
Call it whatever you want, but this does not make for a free market. Instead it’s a market in which people who make bad decisions try to pass the buck to someone else.
In today’s fast moving markets, meltdowns can occur. The best policy is usually to let prices find equilibrium on their own. This is the only way to discover the bottom. A stock (or a house or any other asset) is worth as much as someone is willing to pay for it — no more, no less. Discovering this level is why we have markets.
The knee-jerk reaction, though, when prices are falling is to stop trading. But attempts to interfere almost always backfire.

In last Thursday’s meltdown, the NYSE tried to call a brief time-out because stocks were falling. The computers refused to cooperate.
The government is probably going to respond by muzzling the computers. If they do it, it’ll be a big mistake — and we’ll all pay for it in the next crisis.
Think about it for a minute. Computers can be reprogrammed, and they will be reprogrammed to do whatever their owners think will maximize profit and minimize risk.
So the next time prices fall, for whatever reason, the computerized buyers-of-last-resort may not be there. They’ll stand aside and wait for better opportunities. And that could take a long time.

What does it mean for you? I still see many opportunities in ETF trading, so there’s no need to head for the hills. You do need to pay attention though, and learn two lessons from May 6:

Lesson 1 —

Try to always use a limit order and avoid market orders.

Lesson 2 —

Think long and hard before placing stop-loss orders on ETFs. And if you do, be sure to update them as your holdings rise in price. Otherwise you might end up selling for a whole lot less than you planned.

One way to avoid this is by using a “mental” stop-loss instead of an actual stop-loss order. With a “mental” stop-loss, your computer or broker can alert you if the price is breached and then you can place a limit order.

As always, stay informed and know what you’re doing before you buy.

Best wishes,

Ron

About Money and Markets

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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Dinesh Kalera, Roberto McGrath, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Marty Sleva, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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Resource Allocation
The financial service industry allows you to move resources along a time line. Banks do this by selling investment products and by providing funds for those, who can use them productively. In one sentence: They facilitate a viable allocation of economic resources.
Human life would not be possible without moving resources through time. Every child needs to grow and learn before creating value and earning income. Thus the generic provider of financial services is the family. Parents care for their children and hope to get in return care when they are old.

Accomodation of Cycles
Financial Service companies help us to allocate resources as needed along economic cycles. One example is a life insurance company. You pay a small amount every month for a very long time. You receive in exchange monthly payments after retiring. We use financial services to smooth other types of economic cycles as well. Examples are:

• yearly seasons
• product life cycles
• economic cycles of boom and bust

Every economic cycle contains a time period to invest and another period to profit. Financial services take care of resources which you want to keep for later use and allow yuo to focus your resources where they promise best results.
How is this done? People are born and die, new projects are started and concluded every single day. Some produce currently more resources than they consume. This happens most often in the middle of a life cycle. Others need a current net input of resources. The results can be smoothed by connecting people and projects in different phases.

Speculation
Seasonal cycles and boom/bust cycles of the economy need another type of financial services, the accumulation of tangible goods. For example surplus farm products are stored in summer and autumn. We eat them in winter and spring. Almost no fresh food grows in Europe in January, but hungry mouths are still around.
The Bible describes an archetypical economic boom and bust cycle: The seven fat and the seven meager years, managed by Joseph who stored food in warehouses. The ugly word for his behaviour is “speculation.” But people do not hate the food provided by a speculator. In truth they hate their own myopia, which can be cured at times using financial services provided by speculators, although for a hefty price.