This is the fourth and last part of the blog series on risk. If you have not yet read the past three blogs, I suggest that you read them before you read this one.
One way to measure risk is to see how a security’s return will fluctuate around its long-term average. This is measured through standard deviation. Another way is to compare how a security’s price change varies with that of a benchmark. In the case of bonds, we found out that this can be measured by modified duration.
Just a quick review, modified duration measures the prospective change in a bond’s price relative to a +/- 100 basis point (i.e. 1%) change in interest rates. For stocks, the similar measure is called beta.
To arrive at beta, analysts will plot the historical returns of a stock versus the historical returns of a benchmark such as the Philippine Stock Exchange composite index or PSEi. They will derive the linear equation (i.e. through linear regression) that describes the relationship, if any between the two plotted returns. The comparison can also be done for expected and not just historical returns.
In layman’s terms, if the beta of stock A relative to the PSEi is 1.2, stock A’s price will move 1.2% higher if the PSEi moves up by 1.0% (i.e. 1.2 x 1%). If the PSEi moves down by 1%, stock A’s price will move down by 1.2% (i.e. 1.2 x -1%).
Please note that the relationship between a stock and its benchmark is not one of cause and effect. It is similar to yawning. People tend to yawn when they see or hear another person yawning. There is still no definite explanation why this is so. People just tend to behave this way.
Beta also implies that a stock simply tends to move in an approximate magnitude versus its benchmark. And to make sure that this relationship is significant, another measure called correlation coefficient is derived. Again, don’t worry about the formula because MS Excel does it all. You can even ask for beta and correlation coefficient from your stock broker. A correlation coefficient of 0.70 to 1.0 or -0.70 to -1.0 is said to show a significant correlation. The negative correlation means that a stock can move in the opposite direction of its benchmark.
Just like with modified duration, the higher the beta the more risky the stock will be. The lower the beta, the less risky the stock will be. In fact a beta of below 1.0 means that the magnitude of the change in a stock’s price will be less than that of its benchmark index.
Given the different measures of risk, you the investor can now manage them by allocating your funds in a way that leads to a weighted average risk level that is suitable to your risk profile while still being in line with your target returns. This is called diversification.
Ask your friendly neighborhood financial planner about how best to diversify your portfolio.
(Originally written by Efren Ll. Cruz, RFP at http://www.savingstips.com.ph)
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