You may recall reading an article about “Dealing with Stock Market Risk” last December. To recap, we concluded:
- Diversification is good, but it only deals with individual stock risk. It does nothing to reduce market risk.
- You need to employ dynamic, non-emotional triggers to reduce stock market exposure in falling markets.
The question you should be asking, “Can I measure how much stock market exposure I am taking?” has an easy answer: “Yes, it’s called ‘beta’.”
Beta measures how much your portfolio ought to move up (or down) as compared to how much the stock market moves up (or down). Think of beta as a multiplier: market’s % return X your portfolio’s beta = your portfolio’s % return.
By definition, the beta of the stock market is 1.0. Most broadly, diversified stock portfolios have a beta near 1.0 and thus move pretty much in lock-step with the stock market. So, if the market rises 10%, you should expect your 1.0-beta portfolio to rise 10% (10% x 1.0 = 10%). By the same token, if the market falls 10%, you should expect your 1.0-beta portfolio to drop 10%.
What if your portfolio had a 0.6 beta? You should expect it to move up or down roughly 60% of what the market moved. So, if the market went up 10%, you should expect your 0.6-beta portfolio to rise 6% (10% x 0.6 = 6%). A 10% market decline should lead to a 6% decline in your portfolio.
Use your “dynamic, non-emotional triggers” to manage your portfolio’s beta. You’ll want to lower your beta if the market goes into a downtrend, and you’ll want to raise it back up if the market moves into an uptrend.
Changing Your Beta
How do you change your portfolio’s beta? The simplest way is to change how much stock you have in your portfolio. Let’s say you currently have 100% of your portfolio in stocks. Assuming it’s well-diversified, this would suggest that your portfolio has a beta of 1.0. But now you’d like to reduce this beta to 0.6. To do so, you would lower your stock holdings to 60% and put the other 40% in bonds or cash (or other asset classes not correlated with the stock market). Similarly, you could create any desired beta by dialing in the appropriate amount of stock holdings.
The extreme, of course, would be a portfolio with a beta of 0.0. (You can actually create a portfolio with a negative beta, but that’s beyond the scope of this article.) A 0.0 beta portfolio has no stocks and would be fully defensive, whereas stock market moves would have little, if any, effect on the portfolio.
Ask your financial advisor to give you a recap of your portfolio’s beta, as well as his/her plan to manage this beta as market trends change.
Robert A. “Rocky” Mills is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley in Westlake Village. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates.