There is a strong case to be made that investing heavily in stocks after interest rates have declined will lead to increased stock price. When interest rates are declining banks will be able to borrow money for less. This causes a cascading impact on both consumers and corporations. “It’s not only that higher rates may affect the economy or earnings, but they will also make those future earnings less valuable today” (Hinderstein).
When banks can borrow for less, they can also lend money to consumers for less. Lower rates to borrow money means more money for consumers to spend thus increasing business revenues. On the flip side of the coin, the corporations can also borrow money from the banks for less and will therefore have cheaper rates of borrowed money and greater consumer cashflow. Both avenues for cashflow through businesses will allow for greater company growth and expansion, and as a result greater stock price. This relationship was demonstrated in a study on interest rates and their relation to stock returns in the Spanish stock market. “The sign of the interest rate-stock market link is primarily negative, suggesting that Spanish companies are, on average, benefited by falls in interest rates” (Moya-Martinez, Ferrer-Lapena, & Escribano-Sotos, 2015). This would support that markets generally benefit from lower interest rates; however, this study showed the results to only be significant over long time horizons.
Whether you decide to go with the stock with a low beta would depend on the goal. A low beta with confidence in the stock market performing well in the near future would be a safe investment. This is not a fool-proof method of investment analysis as beta is simply an analysis of past performance, which is a very poor indicator of future stock performance. Despite this, it is one tool that shows the risk of that particular stock is less and if the market is believed to be performing well in the near future than it would certainly seem like a safe investment.
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If the goal is higher risk with higher payoff in the short term, then it may be more beneficial to invest in a different stock. “This is because when markets soar, high beta stocks experience larger gains than the broader market counterparts and thus, outpace their rivals. However, these exhibit a higher level of volatility” (Killa, 2017). If the beta is low, the stock is more stable, thus a lower risk and lower returns. Based on the information provided, and it would also depend on the goal, the stock suggested sounds to be a safe return on investment and I would seriously consider buying that stock.
When it comes to a performance of a stock portfolio, success can be measured by returns, however that will not show the true performance. A 20% annualized return will certainly show that the portfolio is performing and producing substantial returns on the investment, however it does not show the performance in relation to the status of the market and the risk exposure of the portfolio investments. In order to effectively measure performance, the returns would need to be measured in relation to the market and the risk exposure.
One way to measure the portfolio performance would be excess return. “Excess return is a security’s return above or below that of a benchmark or a theoretically risk-free asset such as Treasury bills. Excess return is simply the portfolio’s or security’s return minus that of the benchmark” (Ambrosio, 2007). With measuring the return against a benchmark relevant to the market, it will not only show the return of the portfolio, but how it compared to market fluctuations. Compare the excess return with the asset’s beta (taking into account relative company variation from in risk) in order to measure the return against the portfolio risk exposure. This will compare the returns achieved by the portfolio to a market benchmark and the risk assumed in the process.
A key to a strong portfolio is one that will prevail through dips in difficult markets. If a portfolio is all-in on a specific market, then it will likely not perform strong at many stretches of time when that market is struggling. One way to counter-act that is by diversifying the portfolio with foreign stocks. If the US market is struggling, then there is a balance act, in that it is more likely the foreign stocks are growing, or at the very least, performing better than the struggling market. With a diverse portfolio it will also require slight changes when measuring the performance of the portfolio.
One obvious difference in measuring the success of a portfolio of European stocks would be the market benchmark. The entire portfolio can no longer be measured against US treasury bills as that is not a fair comparison for foreign stocks in a completely different market. The new benchmark for that segment of the portfolio would have to be compared against the fluctuations in the government issued securities of the market chosen. The measurement of the portfolio success would then have to be split between foreign and domestic compared against relative market performance and risk factors. All these factors must be considered in relation to the percentage of the portfolio that is foreign with additional weight in the fact that the portfolio is more diverse and thus more adverse to the effects of a single uneven market.
References
- Ambrosio, F. J. (2007). An Evaluation of Risk Metrics [PDF]. Valley Forge: The Vanguard Group, Inc.
- Hinderstein, C. (n.d.). The Effect of Interest Rates on Market Valuation [PDF]. Baird.
- Killa, S. (2017, October 05). High Beta ETFs & Stocks for Market-Beating Returns. Retrieved November 10, 2018, from https://www.nasdaq.com/article/high-beta-etfs-stocks-for-market-beating-returns-cm855735
- Moya-Martinez, P., Ferrer-Lapena, R., & Escribano-Sotos, F. (2015). Interest Rate Changes and Stock Returns in Spain: A Wavelet Analysis. Business Research Quarterly, 18(2), 95-110. Retrieved November 8, 2018.
