Sir Isaac Newton was a genius who gave us the three laws of motion. Unfortunately his genius did not extend to investing. He tried his hand at investing, lost money and said "I can calculate the movement of the stars, but not the madness of men."
The month of May was one which can be characterised as one driven by the madness of men.
Here are some of the headlines from the period:
"U.S. stock market 'fear' index up 88% for the week" – MarketWatch
"Global Markets Now Infected with Europe Fear" – Yahoo! Finance
"Australian sharemarket falls for fourth straight session." – The Australian
When fear rules the market and we have big moves, it's a trader's heaven and an investor's nightmare.
So for investors who decide to stick with the market in times of volatility, what tools can be used?
During this period, I had to put together a speculative portfolio of shares.
Now, usually you would expect a portfolio like this to lose more than the market because of its speculative or risky nature.
But here's what happened... my portfolio performed better than the market!
How you might ask? Well, the secret is to play with the madness of the market. And more importantly, go 'beta mad'!
Traditionally, if you hold less risky assets during volatility, you can weather the storm better than if you hold high risk assets.
You can experience this phenomenon in the sharemarket most days.
For example, when the sharemarket is going up, the higher risk sectors such as material, energy, industrial, discretionary will usually go up the most. The lower risk sectors such as healthcare, utilities, telecom and staples will lag.
And when the sharemarketing is going down, the opposite tends to be true with the higher risk sectors usually going down and the lower risk sectors going up.
So over the last month, with the sharemarket going down, you would think that my speculative portfolio with high risk assets would have fallen too.
Here's why it didn't...
So what is beta?
Beta is how we measure risk in the market. The market is considered to be neutral so it has a beta of 1. Any stock with a beta more than 1 is considered higher risk than the market and any beta with a lower risk is considered less risk.
This beta is based on historical movements so there is an element of error involved because we can't predict the future.
You can easily find beta for stocks on the Bell Direct site – just go to the Quotes page for the stock you're interested in and choose the Research button to access Key Measures. You'll find 'Beta' in the 'Risk' table. (Read more about Bell Direct's key measures.)
Beta for shares and beta for portfolios are different.
When shares are mixed into a portfolio, they react and produce a different beta. For example, if you have a group of high risk shares in a portfolio, the risk of the overall combination is less risky than you would expect.
To construct your portfolio with an eye on beta, make sure you have an even mix of stocks with have positive betas (eg BHP has 1.03) and negative betas (eg WOW has 0.63).
In my case, my speculative portfolio performed better than the market mainly because it had a beta of 0.8.
Don't get me wrong – I'm not trying to brag! What I hope you'll see is the true beauty of diversification. Holding a group of high risk assets, when combined, can actually be lower risk. And this will help you navigate through the madness of the market.
The key to diversification is to choose assets that don't move together in the same way in the sharemarket. In technical terms, this is all about correlation. So what you want in your portfolio are shares that aren't highly correlated.
For example, if you had a portfolio with the big four banks, you would not well diversified because these are all similar assets which tend to move together in the same way in the sharemarket.
So when sharemarket is going crazy, it's heaven for traders.
But for investors, it's a little harder.
That's because the one thing out of an investor's control is return. However, investors do have control over risk.
Diversification truly is one of the most magical concepts in the market. It's the principle that when assets are mixed together, they combine to form something quite unique. Which is why you can have high risk assets that when combined, become less risky as a group.
The secret is to choose assets that don't move together.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.