On this website, I make a lot of mention about risk. Of course, I have to… Any measured fundamental analyst worth his salt has to, because it’s literally half of the equation we should all use to determine whether an investment makes sense: Risk Vs. Reward. Do you want a lot of reward, you can get it over a long period of time. Want it quickly, you have to add more risk. Minimizing that reality is how we get bubbles like 2021.
Usually though, I talk about risk in terms of a single equity or the market as a whole, but never really at a portfolio level. The reason for this comes from something Warren Buffett famously outlined: if you have a winner, don’t dilute it. There are only so many high-conviction opportunities out there. If you find one, don’t reduce your exposure to that potential gain, and over time you will win. I personally subscribe to that theory, but, for many people, that risk and volatility is too much and diversification is needed.
So how should that diversification manifest in your portfolio? Well, it depends on what you want, but it basically means that you need a wider concentration of assets. This could be by class - starting to hold physical bullion or futures of other commodities, adding bonds… All of this will allow your total asset value to go up and down at different times and for different reasons. It could also mean diversifying just by sector or industry. Meaning you don’t only buy equities in tech companies, but add in some CPG and Healthcare stocks as well.
Now that we’ve established how and why you might want to diversify, how would you actually measure the diversification of your portfolio. This is where beta comes in. It is in effect a statistical measurement which boils down the correlation of two assets to one easy to understand number. Usually it’s used to compare the volatility of a particular stock to an index like the S&P 500. A beta of 1, means an identical movement - the asset exactly mirrors the moves of the S&P 500. Comparatively, a value below 1 means a lower move (S&P move 1%, the stock might move only 80 bps), and a value above 1 is a higher magnitude move. There are also equities which hold a negative beta value. This suggests a negative correlation with the underlying index, when it goes up, the security will drop and vice-versa.
This statistical measurement is a way that you can actually ensure that you hold asset classes which are not fully correlated and provide a resistance to volatility. Of course, beta is based solely on past performance, which is obviously not a guarantee of future returns, but still gives you a good sense of how differentiated those assets are. For example, Treasuries are usually inverted to equities because of the different views investors hold on the economy. In good times, more capital flows into equities, while money is removed from treasuries and yields go up (meaning value goes down) because there is less desire for safe haven assets. During bad times, more money flows into safer treasuries, meaning that the yield goes down (value of existing contracts goes up). This relationship can allow you to predict how your portfolio will perform over time and how likely these different assets are to follow one another. For example, if an equity has a beta of 1, of course that doesn’t mean it’s not necessarily a good investment, but if it exactly follows the S&P 500, that suggests that it might not be worth the risk of owning just the one equity or asset.
Hope this has given you guys a better sense of how risk management works, how to evaluate it and why it could be important…
Written by: Mateo Gjinali