Diversification is usually the biggest safety consideration investors take into account when building their portfolios.
You may have heard that building a portfolio takes three essential items: diversification, diversification, diversification. This concept is certainly an essential part of managing portfolio risk, but there are a few other key aspects of risk that don’t receive enough attention.
Volatility is part of the risk equation and isn’t addressed through diversification alone. How a stock, or even an entire portfolio, performs over time can vary dramatically. Aggressive investors looking for higher gains and willing to take on higher risks will see higher swings in prices than conservative, risk-adverse investors.
If this all sounds overwhelming, there’s good news: figuring out how exposed you are to various risks is easily calculable and doesn’t require a background in finance or mathematics to execute properly.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
Understanding What Risk Really Means
The term ‘risk’ is bandied about on Wall Street without much context to give investors some idea of what it actually refers to. In practice, risk isn’t inherently bad when it’s being used to describe volatility. The VIX Volatility Index unfairly gets a bad rap from investors who see high volatility as ‘bad’ and low volatility as ‘good.’ But low volatility can be a more insidious threat to your portfolio than you might think.
Retirement planning uses risk to determine both your risk tolerance and the expected return of your portfolio. The latter is important because without that kind of estimate, there’s no way to know if you are on track with your investments for retirement.
A conservative portfolio might be low risk, but it’s also low reward; returns can often be under 6% annually. An aggressive portfolio, on the other hand, is more volatile, but can generate returns that meet or exceed market averages. If you know you need to earn 8% or more on your investments to keep up with your retirement plan, you don’t want to reduce risk too much or you’ll end up underperforming and won’t have enough money to retire.
Assessing Risk Using Beta
Beta is one of the most underappreciated ratios that investors have available to them. This ratio basically tells you what a security’s volatility is relative to the market average. A beta of 1.0 means that the asset performs in line with the market average. In other words, a 1% gain in the index will usually translate into a 1% gain for that asset. A beta of more than 1 means that it will experience larger degrees of volatility compared to the averages, whereas a beta of less than 1 usually means the asset will have smaller swings.
Typically, betas at or near 0 indicate an asset that isn’t strongly correlated with market indexes and may behave according to its own industry or business cycle rather than the broader economic cycle. Some stocks can have a negative beta value as well where an asset is actually inversely correlated with the market ( i.e., it will be a down day for the S&P 500 but an up day for that stock).
Let’s take a look at a hypothetical portfolio to examine how we can assess risk a little more closely.
| Ticker Symbol | Price | # of Shares Held | Total Value | % of Portfolio | Beta | Expected Return |
| XOM | $62.67 | 150 | $9,400.50 | 18.30% | 1.33 | 10% |
| JPM | $166.96 | 60 | $10,017.60 | 19.50% | 1.16 | 8% |
| AMD | $112.04 | 100 | $11,204 | 21.80% | 2.01 | 15% |
| GOLD | $19.13 | 525 | $10,043.25 | 19.50% | 0.33 | 20% |
| CVS | $85.96 | 125 | $10,745 | 20.90% | 0.79 | 8% |
| Portfolio | $51,410.30 | 100% | 1.14 | 12.23% |
- share price as of Oct 21, 2021
In this small five stock portfolio, we can see that the total value is $51,410.35. Based on the number of shares held in each stock and dividing it by the total value of the entire portfolio, we can determine what weight it holds.
You can see that we are relatively diversified in market sectors, but a little overweight in AMD and CVS stocks. In reality, your portfolio will likely have more than five holdings, which makes it a bit easier to avoid being too overweight in any one stock.
Once you determine the weights for each stock, you simply multiply each stock’s beta by the percent weight it holds in the portfolio. For example, XOM constitutes 18.3% of the portfolio’s weight and comes with a beta of 1.33; its weighted beta is (18.3%)x(1.33) = 0.243. Once we get all five weighted beta numbers, we add them up to get our total portfolio weighted beta value of approximately 1.14.
The market’s beta is set at 1.0 so our hypothetical portfolio is a little more volatile than the average index. But let’s take a closer look at our largest holding, AMD, which also happens to be our most volatile holding based on its beta of 2.01. What if we replaced AMD with another tech stock, such as NVDA, which has a much lower beta of 1.40? Assuming the total value is the same as before, that single stock switch-up changes our weighted portfolio beta to exactly 1.0. Our portfolio is now aligned with market volatility expectations.
Using this technique, we can raise or lower our portfolio’s beta simply by swapping out individual stock holdings for a similar one in the same sector to customize your risk exposure.
Make sure to check our Dividend Screener to make sure you are picking the right security for your portfolio. You can also select securities that are rated high on our proprietary Dividend.com Rating system.
Guarding Against Unwanted Risks and Returns
To effectively hedge your portfolio risk, you’ll need to plan your investment infrastructure ahead of time. That means choosing your investments carefully to diversify in market sector exposure, market capitalization, and assumed volatility (beta).
Using the same technique we discussed above for calculating your portfolio’s weighted beta ratio, you can also determine your overall expected return. Using the same data as above, our hypothetical portfolio should have an expected return of 12.23%, which is better than the historical average of the S&P 500.
The Bottom Line
Using these key risk assessment tools will help you to more accurately design a portfolio that matches your risk tolerance and your expected return value.
Some risks are too difficult to quantify or guard against beyond maintaining proper portfolio diversification. Systemic market risks or ‘black swan’ events are unpredictable threats that no portfolio can be safeguarded against.
But keeping these simple math tools handy for your investments will help you manage risk and stay on track for retirement.
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