The problem with investments that all go up at the same time is that they'll often go down at the same time, too. That's why so many preach the benefits of asset allocation: the practice of spreading your investments among different classes of assets that move differently in most market conditions. The goal of asset allocation is simple: better performance with less volatility. But how do you tell how an asset is likely to behave? Sometimes it's obvious: Generally speaking, stock market performance lags when interest rates are high (making money market funds and bonds more attractive), for example.
But sometimes it's not so obvious. For instance, if you own both Fidelity Blue Chip Value and Fidelity Growth & Income II -- two funds with different objectives -- you might think you have significant diversification. But because both of them hold big positions in Citigroup (NYSE: C ) , Procter & Gamble (NYSE: PG ) , and ExxonMobil (NYSE: XOM ) , are you really diversified? Fortunately, there are a couple of statistical measures we can use to get a quick handle on how a given fund has behaved compared with the larger market.
The way to beta
Beta is a statistical measure of volatility -- how drastically a fund's (or stock's) price tends to swing compared with the market. A beta of 1 means that the fund tends to move up and down exactly in proportion with the market -- if the market trades within a 5% range over a given period, the security will trade within a 5% range, too. A beta higher than 1 means that the security is more volatile -- if the market stays within a 5% range, a fund with a beta of 1.2 will theoretically stay within a 6% range, for example. Generally, boring stocks like utilities have betas well below 1, while white-knuckle stocks like biotechs have betas way above 1. A higher beta offers the possibility of higher returns -- but also higher risk.
A couple of caveats about beta:
- Beta is a long-term measure. Just because the market is up 3% today doesn't mean that a fund with a beta of 1 will be up 3%, too. Think of it as a measure of how jumpy the fund has been over time, not how closely it follows the market day-to-day.
- Beta is based on past performance. Like all statistical measures, beta is calculated in hindsight. There's no guarantee that a fund with a beta of 0.8 won't become much more volatile than the overall market in the future; it's just statistically unlikely based on past performance.
So beta is useful to help us set general expectations around volatility. But what about a correlation with daily market movements?
I'm glad you asked. R-squared is a measure of correlation, and despite its nerdy name, it's quite easy to understand. R-squared seeks to tell us, on a range from 0% to 100%, how much of a security's price movement can be explained by movements in a chosen benchmark index. An index fund, for example, should have an R-squared very close to 100%, meaning it (obviously) moves up and down just as the index does. An aggressive small-cap fund, on the other hand, might have an R-squared around 60% in relation to the S&P 500. Again, this is based on past performance, so take that into consideration.
R-squared is a great way to check up on fund managers, by the way: If a supposedly unrestricted growth fund has an R-squared near 100%, and its performance is close to its benchmark's, the manager might just be mimicking his benchmark rather than adding value. If the fund also has a beta near 1, be doubly suspicious: For all intents and purposes, you could be looking at an index fund. Check the performance to see if your manager has created alpha by beating the benchmark. If not, don't pay active-management fees for something that behaves like an index fund.
Putting the pieces together
Before I put it all together, I want to emphasize one point: "Benchmarks" vary. The Yahoo! Finance site uses the S&P 500 for everything, which makes fund-to-fund comparisons useful but won't tell you if, say, a small-cap fund's manager is just mimicking his benchmark. Other sites -- like fund company pages -- may use the fund's official benchmarks instead. Make sure you're comparing apples to apples.
Looking at these numbers for the stock funds you own (you can find them on your fund's "Risk" page at Yahoo! Finance) can help you figure out how different they really are. Going back to those two Fidelity funds, Growth & Income II has a beta of 0.89 and an R-squared of 85% over the last three years, and Blue Chip Value's numbers are 1.09 and 90%, respectively.
At first glance, I'd say that Blue Chip Value is somewhat more volatile, but they're both hanging pretty close to the broader market -- and to each other. If I had my stock holdings split between the two, I'd think hard about replacing one with a good small-cap or mid-cap fund that had a lower R-squared. Doing that would give me some insulation when the big stocks preferred by both funds lag the market, and would stand a good chance of improving my portfolio's performance over time.
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Fool contributor John Rosevear loves low beta, especially when it comes with high alpha. He doesn't own any of the stocks or funds mentioned. The Motley Fool's disclosure policy once eta potato with Greek dressing, but usually prefers to beta hook and catch a fish instead.