Beta & AlphaRisk Management
Measuring a potential trade’s risk against an existing portfolio is testing the asset against a benchmark. The benchmark is usually either an existing portfolio, a market index, or a basket of assets. When measuring an asset relative to an existing portfolio you can see how your potential trade affects existing risks. It can either concentrate and increase existing risk or reduce and diversify existing risk. It can also add potential performance relative to risk or reduce potential performance relative to risk.
Beta & Alpha
Beta is an extremely important measure of volatility compared to a benchmark. This measures the sensitivity of the asset to the benchmark selected, based on historical data. The benchmark always has a beta of one in comparison to the asset. If the asset’s beta is higher than 1, the asset moves in the same direction as the benchmark, but more extreme. If the asset’s beta is 1, it moves the same direction and same degree as the benchmark. If less than 1, it moves the same direction but to a lower degree than the benchmark. If the beta is 0, it is completely uncorrelated in the movement to the benchmark. Note that beta uses historical data, which had different market drivers economically, fundamental, and sentimentally. The beta will change over time, and it should be expected.
If the asset’s beta is negative, it moves in the opposite direction to the benchmark. If the benchmark goes up, the asset goes down. If between -0.01 and -1.0, it moves the opposite direction to a lower degree than the benchmark. If the asset’s beta is lower than -1, the asset moves in the opposite direction as the benchmark, but more extreme. If the asset’s beta is -1, it moves in the opposite direction but the same degree as the benchmark.
When seeking new investments, I look for betas that have low or no correlation to the market and to existing assets in the portfolio. It decreases the portfolio’s standard deviation, diversifying my risk.
Alpha is the return you can expect relative to a benchmark. The benchmark is always zero and the alpha is either positive or negative. If an investment has positive alpha, it should deliver positive return relative to the benchmark. If an investment has negative alpha, the investment should deliver lower return relative to the benchmark. If the market is the benchmark, seeking alpha helps to beat the market. For long positions, I seek assets with positive alpha in recent historical periods. For shorts, I prefer deep negative alpha. Seeking alpha in recent periods increases likelihood economic trends creating the alpha are still active.
Beta & Portfolio Diversification
Standard deviations exist at two levels: the asset level and the portfolio level. Imagine your portfolio was made entirely of one asset and that asset decreased 20% in price. Your portfolio would also decrease that full 20%. Now image you had a portfolio divided equally among 25 owned assets, and one asset moved down 20% while the rest stayed the same. You would suffer a significantly smaller loss. The more investments you have, the lower each asset’s contribution to your portfolio’s deviations, which is your risk.
Each asset with a positive beta is positively correlated to the market. To a degree, some of each asset’s return (and its standard deviation) comes directly from the market’s movements, its market correlation. At some point, it becomes extremely difficult to reduce deviation from the market. Diminishing returns eventually take over. Assuming normal distribution, a single asset portfolio would have a standard deviation of 50. Generally, you can never be below a normal distribution standard deviation of 19 while holding all long positions. It simply reduces you to roughly the market’s standard deviation. That occurs at 1,000 or more assets from one market, like the S&P500. At 50 assets you’ve reduced portfolio standard deviation to roughly 21. Moving from 50 to 950 assets is not worth the small decrease. At 1,000 assets you should just buy an index fund. Diversifying up to 50 assets while aware of beta and correlation is a reasonable enough usage of time versus benefit.
However, there are ways to reduce the non-diversifiable risk. This is where mixed long and short portfolios enter the picture. A Long/Short fund will buy assets it thinks will rise and short sell assets it believes will maintain a downtrend over a period of time. This can occur for a variety of fundamental, economic, or quantitative reasons. These short sales hedge market risk. When the market decreases short sold, undesirable assets will decrease as well. Gains from these short sales cancel the losses from assets bought. When the market rises, many of these assets are left behind, but they will occasionally rise with the market.
But be warned: Short sales have an unlimited potential loss since prices can rise infinitely. If an acquisition occurs or very positive news comes out, the price of an asset gaps up, creating losses on a short sale that can double (or more) very quickly. This destroys many short sellers, who must buy the asset back to cover their position at a significantly higher loss than expected. This can be a huge loss for short sales with illiquid assets or low available shares, and often kills accounts with concentrated risks.
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International Economic Analysis:
- Major Currency Economic Summaries
- Performance of Major Imports and Exports
- Mandates of Central Banks versus Expectations
- Performance Indexes of Major Economies
- Economically Correlated Currency Projections
- Large Funds Currency Sentiment Readings
- List of Technical Indicators to Look For
- Occasional: Foregin Exchange Technicals Markups
American Markets Analysis:
- Summaries of American Economic Structure
- Performance of Major
- Federal Reserve Mandate versus Expectations
- Performance Indexes of U.S Economy
- Economically Correlated U.S Dollar Projections
- Large Trading Fund Index Sentiment Readings
- Market Wide Earnings Versus Valuations
- Fundamental Ranking of U.S Business Sectors
- Best and Worst Future Consensus Estimates
- Occasional: Firm Fundamental Strength Report
- List of Technicals to Look for While Trading
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