When an investment portfolio is being designed, there are a few basic factors to consider. What is your age? What are your savings goals? Do you know the type of returns do you expect to earn from your investments? The most important factor to consider is much risk can you tolerate? Using beta to measure investment risk is a great measurement to review.
When the stock market is soaring, investors tend to forget about risk. Who wants to dampen the performance of their portfolio and miss out on the double-digit bull market returns? It does not matter if you are an aggressive investor in your prime earning years or a more conservative investor who is nearing retirement when the markets start to get volatile, most investors tend to become more focused on risk management and risk tolerance.
It is important to know how risky the investments that make up your portfolio are. One of the best ways to measure volatility is to measure the beta of an investment. Beta is the second character of the Greek Alphabet. Beta is used to determine how volatile an investment is in relation to its benchmark.
When measuring beta, the baseline is 1. If an individual share of a publicly traded company, an EFT, or a mutual fund has a beta of 1, it moves exactly in step with its benchmark. If an individual equity, ETF, or mutual fund has a beta that is greater than 1, the investment is more volatile than the benchmark that it tracks. On the other hand, if an investment has a beta of less than 1, it would be less volatile than its benchmark.
In other words, beta is the risk measurement of investing in the stock market. The stock market has a systematic risk. If an investor wants to reduce the volatility of a market portfolio, they might want to consider adding some investments with a beta that is less than 1.
Investors who invest in a portfolio constructed of passive investments would generally be considered beta investors. That is especially true for those who invest in broad market portfolios. Investments such as large-cap index funds would have a beta of 1. For example, an S&P 500 index would have a beta of 1 because it tracks the S&P 500 index. Investors who invest in a portfolio that incorporates bonds into their mix would have less volatility than a portfolio made up of only stocks because the beta would be less than 1.
Below are a few mutual funds to consider if you are looking for a low beta option:
Fidelity Growth Strategies Fund FDEGX
Fidelity Low-Priced Stock Fund FLPSX
Fidelity Small Cap Growth Fund FCPGX
Vanguard Wellington Fund Investor Shares VWELX
What are some investments that have a beta that is greater than 1? It is not uncommon for actively managed mutual funds to have a beta higher than 1. That is because fund managers are trying to beat the market. There are index funds as well as ETFs that also have a beta higher than 1. Micro-Cap funds and emerging markets tend to have a beta higher than 1.
Some examples of funds with a high beta are:
ALPS Medical Breakthroughs EFT SBIO
Consumer Discretionary Select Sector SPDS Fund XLY
Fidelity Nasdaq Composite Index Tracking Stock ONEQ
First Trust Dow Jones Select Micro-Cap Index Fund FDM
While the beta is used to measure risk, alpha is the benchmark that measures market-beating performance. Alpha is the goal of active managers. Alpha is the Holy Grail of active management. Those who consistently produce alpha become legends. Those who don’t ultimately receive a pink slip.
Many investors would like a portfolio that has both a low beta score and a high alpha. Building a portfolio that has the combination of low-volatility and market-beating returns is very hard to accomplish. That is why most active fund managers do not succeed.
Alpha is based on PR – [RF + Beta * (MR – RF)]
PR is the return produced by the investment portfolio
RF is the risk-free rate of return (Treasury Bonds)
MR is the market return
It is very difficult for active fund managers to consistently produce market-beating returns. It is possible in the short-term, but the vast majority of managers do not beat their benchmark over long periods of time. Most produce a negative alpha beyond 5 years.
It is almost impossible for individual investors to produce market-beating returns year after year. Individual investors have a more difficult time than professional investors because they do not possess the resources or information that professional fund managers possess. It would be easier for an individual investor to use beta to help in designing a portfolio than trying to produce long-term alpha.
There are many factors to consider when building an investment portfolio. Beta is one of many measurements to use as a guide. It is not the sole measurement that should be the determining factor when trying to decide if an investment fits in with the rest of your portfolio.
Focus on learning how much real-world risk you can tolerate. Could you tolerate a (50%) drop in the value of your portfolio? If not, a portfolio of 100% invested in stocks might not be for you. How about a (20%) drop? If that sounds more bearable, you should consider a more balanced portfolio. To help track your portfolio, consider using Personal Capital to monitor your asset allocation and performance.
Before you ever make an investment decision, be sure to check with an investment professional.
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