Taking Stock: Diversification Can Take Some Of The Volatility Out Of Tech Investing

A diversified portfolio is the best bet for most investors.
A couple of years ago, it seemed like the biggest risk facing technology investors was missing out on a stellar return. Now, it appears that the biggest risk of tech investing is owning these stocks at all, as they've underperformed the overall stock market by a wide margin. Have tech stocks become riskier investments, or should we have expected such volatility?

There are several ways to assess the riskiness of a particular stock. One way is to look at the standard deviation of the stock's price over a time period, say five years. The standard deviation tells you how wide the swings in the stock's price have been. Even though this figure is based on historical data, it's not a bad starting point for assessing future volatility.

But keep in mind that the future often doesn't look like the past. For example, Microsoft's stock price had a standard deviation of 19% over the last five years, while the stock returned about 8% per year. This means that for any of the past five years, there would be a 68% probability that the stock would return between-11% and 27%.

Another way to view risk is to examine a stock's performance relative to the overall stock market. This concept is boiled down into a single number that's called beta. The beta for a stock shows how much you should expect that stock to increase when the overall market is up 1%. If a stock has a beta of 1, it rises and falls in line with the market. However, most technology stocks have betas that are significantly higher than 1.

This is probably what you'd expect with tech stocks appreciating more than the market, at least in up markets. For example, Intel has a beta of 1.7. This implies that if the stock market were up 1%, Intel's stock should be up 1.7%. Several other large tech stocks also have betas in this range. Cisco Systems' is 1.9, Microsoft's is 1.7, and Oracle's is 1.67. Size also matters--typically, the smaller a company, the more volatile its stock (i.e., a higher beta).

In theory, a stock with a certain beta should also decline the same if the market falls. That is, if the overall market were down 1%, Intel should be down 1.7%. Unfortunately, this isn't always the case.

Look at the past five years in the tech market. First there was a wild ride to unfathomable heights, followed by a devastating plunge. Let's take Sun Microsystems. Back in August 1997, let's say you were looking to add Sun to your portfolio. Checking Sun's beta, you discover that it's 0.96, indicating that Sun should rise and fall roughly in sync with the market.

In reality, Sun vastly outperformed the market as it was rising, but also severely underperformed as the market crashed. A quick check today shows that Sun's beta has risen to 2.29. This means that although Sun didn't appear much riskier than the overall market five years ago, it turned out in a down market that the beta was much higher than in an up market. Not a very pleasant surprise for investors. Viewed from a different angle, investors today demand a higher expected return for investing in tech stocks than they did five years ago.

A diverse portfolio would mitigate some of this risk by including other asset classes such as non-tech large cap stocks, small cap stocks, real-estate investment trusts, international stocks, and perhaps even some bonds. The key is that these asset classes aren't correlated and don't move up or down in sync. Instead, when tech stocks are falling, real-estate investment trusts tend to be rising. One not-so-obvious benefit is that adding asset classes that are volatile but not correlated can lower the volatility of the portfolio as a whole.

The same holds for individual stocks in a portfolio. I2, Manugistics, PeopleSoft, and Siebel Systems all are subject to the same forces, whereas owning different types of technology would increase the diversification of the portfolio.

Tech stocks have a place in a portfolio, but for most people, a fully diversified portfolio will serve their needs better in the long run and maybe even calm those frayed nerves.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].

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