How To Measure The Risk In Your Portfolio
How can you figure out how much downside risk an investment exposes you to? Answering this critical question can be tricky. There are so many ways to calculate risk. On top of that, many risk measures have their own limitations. And then there's the separate question of how you should use the risk barometers you pick. But there is one rule you should always follow. Although it is easy to get a separate risk reading on each of your investments, you should care only about how your portfolio rates as a whole.
It's important to go for the big picture because a diversified portfolio carries less risk than the sum of its parts. The reason is that in a diversified portfolio, individual components - such as stocks and bonds - are unlikely to move in sync, especially over the long term. Thus, each can offset some of the other's risk. The volatility of stocks, for instance, could be balanced out by the fixed interest and principal payments of bonds.
It's hard to grab a calculator and arrive at a figure that reflects the overall risk in a portfolio. Still, a back-of-the-envelope reckoning provides a rough, though inflated gauge. Just research the risk scores on each investment and multiply by their percentage weightings in your portfolio. Then calculate an average. It's not ideal, because it fails to account for diversification's risk-reducing magic. (It goes without saying that if you are diversified then your risk is probably going to be less!)
For something more accurate, you can use a free Web service such as Financialengines.com to assess how risky your portfolio is, compared with that of the average investor. To define risk, Financialengines uses the measure known as standard deviation, which it expresses as a numerical score. For instance, if the rating on your portfolio is 1.4, then you are taking 40% more risk than the average of 1.0.
Whatever approach you take, the results will be easier to interpret if you have a grasp of how professionals measure financial risk. When it comes to stocks, investors confront two types of risk. One is posed by market downdrafts, which can punish even the most worthy investments. The other consists of problems specific to companies, such as mismanagement or obsolete products. For mutual funds, there is a third variety of risk, which is posed by a bad manager who charges high fees and doesn't make enough to recoup that cost.
Happily, about 96% of company-specific risk can be eliminated simply by owning a diversified portfolio of 40 to 50 stocks. The risk that remains - a loss due to a market sell-off - is captured in a measure called beta. Beta compares the magnitude of an investment's price-swings with the market's overall fluctuations.
Appealing, because of its simplicity, beta is sometimes too crude to be useful. For one thing, it is often calculated compared to the S&P 500, a large-cap measure that is a poor yardstick for other asset classes. To find out whether you can trust beta to give you an accurate picture of an investment's risk, look up another statistical measure, R-squared. This tells you the degree to which an investment's price rises and falls at the same time as the benchmark it is being compared to. An investment's beta can be considered reliable only if its R-squared falls between 85 and 100, meaning that it closely tracks the index.
When confronted with a low R-squared, find a beta based on a better benchmark. For mutual funds, Morningstar.com publishes betas that use both the S&P and the most appropriate index. For stocks, Personalwealth.com tailors betas to peer groups, such as computer hardware stocks. But be wary of beta when a company or fund specializes in fast-changing technologies. In such instances the beta is going to change rapidly. Of course, if your holdings are not diversified, it can be dangerous to rely on beta at all, because when it comes to individual stocks, beta explains only 35% of the risk. The rest is due to company-specific developments.
* * * * *
It's important to go for the big picture because a diversified portfolio carries less risk than the sum of its parts. The reason is that in a diversified portfolio, individual components - such as stocks and bonds - are unlikely to move in sync, especially over the long term. Thus, each can offset some of the other's risk. The volatility of stocks, for instance, could be balanced out by the fixed interest and principal payments of bonds.
It's hard to grab a calculator and arrive at a figure that reflects the overall risk in a portfolio. Still, a back-of-the-envelope reckoning provides a rough, though inflated gauge. Just research the risk scores on each investment and multiply by their percentage weightings in your portfolio. Then calculate an average. It's not ideal, because it fails to account for diversification's risk-reducing magic. (It goes without saying that if you are diversified then your risk is probably going to be less!)
For something more accurate, you can use a free Web service such as Financialengines.com to assess how risky your portfolio is, compared with that of the average investor. To define risk, Financialengines uses the measure known as standard deviation, which it expresses as a numerical score. For instance, if the rating on your portfolio is 1.4, then you are taking 40% more risk than the average of 1.0.
Whatever approach you take, the results will be easier to interpret if you have a grasp of how professionals measure financial risk. When it comes to stocks, investors confront two types of risk. One is posed by market downdrafts, which can punish even the most worthy investments. The other consists of problems specific to companies, such as mismanagement or obsolete products. For mutual funds, there is a third variety of risk, which is posed by a bad manager who charges high fees and doesn't make enough to recoup that cost.
Happily, about 96% of company-specific risk can be eliminated simply by owning a diversified portfolio of 40 to 50 stocks. The risk that remains - a loss due to a market sell-off - is captured in a measure called beta. Beta compares the magnitude of an investment's price-swings with the market's overall fluctuations.
Appealing, because of its simplicity, beta is sometimes too crude to be useful. For one thing, it is often calculated compared to the S&P 500, a large-cap measure that is a poor yardstick for other asset classes. To find out whether you can trust beta to give you an accurate picture of an investment's risk, look up another statistical measure, R-squared. This tells you the degree to which an investment's price rises and falls at the same time as the benchmark it is being compared to. An investment's beta can be considered reliable only if its R-squared falls between 85 and 100, meaning that it closely tracks the index.
When confronted with a low R-squared, find a beta based on a better benchmark. For mutual funds, Morningstar.com publishes betas that use both the S&P and the most appropriate index. For stocks, Personalwealth.com tailors betas to peer groups, such as computer hardware stocks. But be wary of beta when a company or fund specializes in fast-changing technologies. In such instances the beta is going to change rapidly. Of course, if your holdings are not diversified, it can be dangerous to rely on beta at all, because when it comes to individual stocks, beta explains only 35% of the risk. The rest is due to company-specific developments.
* * * * *
posted by Bob Moser at
4:59 PM
0 Comments:
Post a Comment
<< Home