Be Financially Free by Morten Strange

Be Financially Free by Morten Strange

Author:Morten Strange
Language: eng
Format: epub
ISBN: 9789814751780
Publisher: Marshall Cavendish International

A bit about risk

One financial metric we didn’t cover in the last chapter is beta value (represented in financial formulas by the Greek letter β). I find it useful when considering the composition of your portfolio and risk management. I didn’t include it earlier because Yahoo Finance does not provide a beta for either Sembcorp Industries or Hyflux, but you can find it from other sources. The SGX calculates a beta for Sembcorp over five years of 1.28, while for Hyflux it is 0.74.

The beta indicates how much the stock price deviates over a period of time from the market as whole. A beta of 1 means that the share moves in exact tandem with the market. A beta of 1.2 means that it is 20% more volatile as compared to the market as a whole. If the market moves up 10 points, the stock will move up 12; if the market is down 10, the stock is down 12. A beta of 0.8 means that the stock moves less than the market, 8 versus 10 points up or down. A high beta stock (β > 1) is considered a risky stock; a low beta stock (β < 1) is less risky.

For a risky stock, you as an investor would require a higher rate of return to make it worth the risk of holding it; for a low beta stock, the required rate could be lower. The beta of a totally risk-free investment, such as cash in the bank supported by government deposit insurance, will have a beta of zero. Otherwise, beta will always be more than zero (although for inverse products such as inverse ETFs designed to short the market the beta will be negative, i.e. as the index moves up, the short product will move down).

Analysts use the beta value to plot a security market line graph, which is the expected return plotted against the beta. I will not go into it here, interesting as it might be for some. Visit Investopedia.com and key in “CAPM” (the capital asset pricing model) and you’ll find a good explanation there.

Professional fund managers use these tools because they must. As mentioned before, they are expected to “beat the market”, so they need a uniform quantifiable method to gauge if they do or if they don’t. This is how they get promoted or fired and how their fund companies attract new customers or lose capital due to poor returns and withdrawals.

As a private investor, just managing your own savings, you might not have the time or the interest to get into this. But even then, you can fairly easily estimate the expected risk of your stock investment simply by studying how “your” company has fared compared to the index. Go back to your favourite service provider and plot the graph of the company five years back, then click in the relevant index. How do they correlate? If “your” company is all over the place compared to the index, the beta risk is higher.


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