Jul 03
Market Risk Factor
This entry is the first of three where we break down the Fama-French (FF) study into smaller digestible bites. While the main thrust of the FF study concentrated on the Price/Book ratio and market risk, beta was also considered. Remember that FF “could determine with 95% accuracy how a portfolio performed in relation to the stock market without knowing the actual return of the portfolio.”
Ferri, in his book, “All About Asset Allocation,” writes; “On average, about 70 percent of the return of a broadly diversified portfolio is explained by beta, making that factor the most influential in explaining portfolio returns.”
Ferri does not explain where the 70 percent figure comes from, at least I was not able to find the source, but we have all experienced the movement of our portfolio with the gyrations of the total stock market. I was surprised the figure was not higher as most portfolios have a beta values around 0.90 to 1.3. This means the portfolio will move up or down somewhere between 10% and 30% faster or slower than the benchmark.
Market risk is always with us and one of the ways to modify it is to hold a larger percentage in cash and/or bonds so as to lower the beta of the portfolio. There are ETFs that short the market, but we have yet to use that approach to reduce portfolio volatility. Expect to read more about risk in the months ahead.
Lowell Herr
Photograph: Photograph by Ivan Hoding taken in Phuket, Thailand
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