Price elasticity can be a difficult, yet important economic principle to grasp; yet it can help decrease your volatility in the markets. Price elasticity, essentially, is how the demand for products changes relative to the change in the price of the product. It is expressed by the following equation:
Price Elasticity of Demand Formula
In simpler terms, if the price of apples increased by 20% would people buy the same amount of apples? This would be called an inelastic demand. Where people buy the same amount of a product, regardless of price changes. But what if people buy fewer apples? This would be called elastic demand. Where people buy less of a product, because of the price changes.
But where does price elasticity fit in with an investor? Well, companies make things, whether they are goods or services, and they sell them. The price at which they sell those goods and services, directly impacts that company’s earnings and revenue. The types of goods and services that the company produces, can also impact their performance when times are tough and consumers are tightening their budgets. Company’s that produce and sell relatively inelastic goods and services will experience less fluctuation than a company that produces and sells elastic goods and services. This helps decrease your volatility and ultimately helps insulate you from changes in the market conditions.
S&P 500 Consumes Staples compared to S&P 500 Consumer Discretionary’s from 2006 to 2016
Let’s take a closer look at the 2009 economic recession we saw in the United States, particularly comparing the performance of consumer staples, products that consumers need (i.e. food, clothes, etc), compared to consumer discretionary, products that consumers don’t need, but want (i.e. televisions, computers, etc). Look particularly at the performance of the two indexes in 2009 and the recovery up too 2014. Consumer staples and consumer discretionary’s were very comparable in their movements until 2009. At which point consumer discretionary’s fell considerably more than consumer staples. It took nearly five year, about 2014 for the two indexes to become very comparable again. This illustrates, again, that when consumers face tight budgets, as they did during 2009, that they still bought inelastic goods, goods that they needed. As an investor, you want to decrease your volatility, and insure yourself against the market conditions that took place in 2009.
Using price elasticity when you evaluate companies, will help you build a solid portfolio
Companies are always looking to improve their revenues and their earnings, that’s just a fact in the markets.
In doing so though, that means they are going to try and price their goods or services at the most optimal point, and when that point is not as beneficial to them as they would like, then they will consider changing their price structure. Take Facebook (Nasdaq), the company has millions of members all across the globe. Yet when they first became a publicly traded company, there was doubts as to how they would grow their earnings. The idea began floating around that Facebook should begin charging a monthly fee for its users. Through polls and just the general outcry of its consumers Facebook found out that the demand for its services was elastic, and the number of consumers would fall considerably if there was a monthly fee.
Now consider a company that sells an inelastic product, a product that is demanded regardless of its price. Now this is nearly impossible, but look at a product like gasoline, which is about as close to inelastic as a product can be. Consumers use gasoline constantly, and when the prices rise they use it relatively the same amount as before. Sure, they may cut back on some vacation trips, but they will still drive the same amount to work and school. When you invest in a company that sells inelastic goods it, in a sense, insulates you from fluctuation in the demand for goods in the markets, decreasing your volatility.
Companies can be very attractive when all is well in the economy. People are much more willing to spend their income; they’re much more optimistic about their financials and livelihood. But when times are tough, often times the first thing cut from their budgets are consumer discretionary products. As an investor, when you build your portfolio, it’s important to decrease your volatility and decrease the hit your portfolio takes when the markets are in a downturn. Looking at the goods and services that your stocks produce and sell, how they generate their revenue and whether or not those goods and services are elastic or inelastic can help you build a solid portfolio for the long-term.