Hello everyone! In the Starting to Invest series I often speak about the need to diversify investments, and how this is a sensible risk management strategy. Today I’m going to start a series to explain why diversification is a good thing and one of the best tools for getting the most out of your investments. We’re going to start with the idea of being aware of the Beta of what you invest in.
These are going to get a little more technical than some of my posts, but I’m going to explain the more maths based concepts in plain English whenever possible.
Why we want to diversify
Let’s talk about the rationale first of all. The key benefit of diversification is because it allows us to protect ourselves against a sudden change in market direction. Let’s start with a general point:
“If the stock market rises, most underlying shares will be increasing in value. If the stock market falls, most underlying shares will be decreasing in value”.
This is absolutely fantastic when the market is going up – we’re likely to be seeing terrific gains! However when things go down it means everything tumbles down with it in one direction, and things become streaky.
We might just accept this as some of the risk of being invested in the stock market, but it actually doesn’t have to be this way.
The problem is that the stock market tends to go up slowly, usually over the course of series of years. However, when things go down it’s usually rapid and usually through an unexpected shock event. We’re most likely to need to draw from our investments when things go down so (unless you have a high risk tolerance and can wait out losses) it makes sense to limit this downside risk.
Introducing the concept of Beta
So how can we do this?
Well our rule above that a stock is likely to increase with the market doesn’t always hold. There’s a number of markets and products that are counter cyclical – for instance the price of gold and other commodities has tended to rise when there’s downward pressure on the market.
The ratio between the movement of a stock and the underlying market is called the Beta of the investment.
It’s easiest to demonstrate with an example so let’s talk through how this works.
Company X sees it’s share price rise by 10% when the market rises by 10%. This means it has a Beta of 1, or it has a perfect correlation with the market.
Company Y sees it’s share price risk by only 5% when the market rises by 10%. This means it has a Beta of 0.5, or it is somewhat correlated with the market.
Company Y sees it’s share price decreases by 10% when the market rises by 10%. This means it has a Beta of -1.0 and is negatively correlated with the market.
So by picking multiple stocks that we think have good underlying prospects, but a range of Beta’s we can protect ourselves from the effects of the market to some degree. It lets us plan and be aware of the exposure we face to volatility in the wider stock market.
If I cut my Beta down do I just gain nothing?
The point is not to reduce the portfolio Beta to zero – the idea is to have a sense of exactly what level of market volatility you’re exposed to and help control it though sensible asset purchases.
How can I find out what the Beta of a stock is?
Pick you favourite stock ticker site! It’s a relatively common metric that computers can calculate very easily for us, and is usually found listed by a stock price at most good online websites. Occasionally it’ll be found in a metrics or analysis section.
How does Beta build into diversification/risk management?
Well, whilst there’s benefit in knowing your underlying exposure to the market, we’re really going to use this as a building block to underlying benefits of diversification.
Beta is giving us an insight into the risk that is driven more by market than underlying company – so if we believe in the fundamentals of the underlying company but aren’t sure what the market is going to go, ideally we’d want to try and get rid of the outside influence from stock market movements. That’s going to take us through to the next topic to come on this topic of understanding Alpha, and here we’ll look further at that interplay between risk and profit.
If you’re looking to further understand investment concepts like Beta, it can also be worth checking out some of the investing books out there – Simon at Financial Expert has a great selection through that link.