The Curious Investor

Alright, time to get philosophic! Now that you’re armed with tools to analyze stocks and make some picks, it’s time to think about how to build a portfolio. We may all have different goals for our portfolio. Some people may just be looking for a place to grow their savings for retirement. Others may be looking for faster near-term growth in hopes of having more money to spend sooner. Still others may just want to beat the returns of the market. Whatever your goal in investing is, the one thing you’re most concerned about is how to achieve that goal by minimizing risk.

But, what exactly is risk? People are always talking about risky investments and one might think that this is only in reference to investing in companies that are in financial trouble or investing in companies that have more value in their big plans for the future than in any tangible sense. Risk, however, is an actual, quantifiable term. It is, by definition, the standard of deviation of an investment’s expected returns - or its volatility. For the most part, investmenst with higher expected returns will be more volatile than those with lower expectations. For example, your savings account probably returns somewhere between 1.5% to 5% a year every year whereas an investment made in an S&P 500 stock will return on average 12% a year but could fluctuate between -25% and 50% returns (based on returns of the S&P 500 since 1950, see here).

So, how do we analyze risk? One helpful statistic is beta which you can find on most more detailed stock quotes. (Go to Yahoo! Finance and see “Key Statistics” for any stock you search for.) Beta is a statistic which is computed using a regression of a stocks previous price movements compared to that of the stock market. A beta of greater than 1 means that the stock is more volatile than the stock market and a beta of less than 1 means the stock is less volatile.

Should we only invest in stocks with a certain beta, maybe only those which are less volatile than the stock market, in hopes of reducing our risk and getting better returns? Not necessarily. Ultimately, a good portfolio is not measured by the success of each individual investment that is made but by the performance of the portfolio as a whole with regards to whatever goal it is you seek from the portfolio. As such, it is more important to build a portfolio by looking at your overall level of risk as opposed to the risk of individual stocks. For example, if I were to hold a lot of cash but invest in riskier stocks, the overall beta of my portfolio would be lower than that of the risky stocks I invest in. If I feel that I can successfully use these risky stocks can yield high returns, this may be a better option than being fully invested in several less risky investments.

So, how do we do you build a balanced portfolio that will generate the best return for the least risk? Well, it involves a combination of proper valuation, asset allocation, and a little common sense about how your investments fit together. As we continue on in this series, I will delve further into how you can use smart portfolio management to minimize your risk in the stock market.

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