Introduction
I recently wrote about my plan to prepare for the next recession which, in my opinion, is due soon. While thinking about that, a question that came to my mind was: how will my mutual fund portfolio deal with the upcoming recession? To answer that, I wanted to do a risk analysis of the mutual funds that I am using to generate Passive Income Streams. I wrote about my implementation of passive income streams here.
The mutual funds and/or cash driving my passive income streams are listed below for reference. Before I do a risk analysis of my portfolio, we need to understand some terminologies. Lets dive into that next.
| Risk Bucket Name | Investment Vehicle 1 | Investment Vehicle 2 |
| Risk 1 (Cash in banks) | Smarty Pig (online) | Credit Union (brick & mortar) |
| Risk 2 (Bonds) | VCAIX (ca munis) | N/A |
| Risk 3 (Balanced Funds) | VTMFX (has natl munis) | N/A |
| Risk 4 (Dividend Investing) | VDIGX (div growth) | VHDYX (high curr div) |
| Risk 5 (Capital Growth) | VTCLX (large+mid cap) | VTMSX (small cap) |
| Risk 5 (International Funds) | VTMGX (large blend) | N/A |
Risk of a mutual fund
When we talk about the risk analysis of a mutual fund OR the volatility of a mutual fund, we often compare it to the market as a whole. For example, if the market goes through a volatile phase, will the mutual fund also be volatile OR will it be stable OR will it reach inversely to the market?
Consider one example. In a recession OR a down market, most people will conserve money and not buy new cars. Most people will repair their current cars and postpone purchase of a new car to when the market is up.
- If you own stocks of companies that manufacture new cars, when the market goes down, such stocks will also go down.
- Greater risk in a down market, but greater reward in an up market
- If you own stocks of companies that manufacture automotive replacement parts, then when the market goes down, replacement parts companies make money and hence such stocks will go up.
- Greater risk in an up market, but greater reward in a down market.
- If you own stocks of companies that provide water supply to people, such stocks remain calm when the market goes up or down.
- Low risk, Low reward.
A metric used by many investors to compare a mutual fund/stock/portfolio to the entire market is called the Beta Coefficient.
Beta Coefficient
If you had asked me last year, I would have said that “beta coefficient” looks like a very geeky mathematical name i.e. something I had ignored often as too complicated. It is complicated math but I have found a nice and easy way to understand it. Lets define it my way.
Beta Coefficient of a mutual fund/stock/portfolio is a measure of the risk that shows up when the mutual fund/stock/portfolio is exposed to different types of market conditions like an up market, down market, recession, etc.
Some common values of Beta Coefficient will help make it clearer:
- A beta of less than 1 means that the mutual fund/stock/portfolio will be less volatile than the market.
- The water company example above
- A beta of greater than 1 indicates that the price of the mutual fund/stock/portfolio will be more volatile than the market.
- If a stock’s beta is 1.5, it’s theoretically 50% more volatile than the market.
- For example, the new car company stocks.
- A negative beta indicates a counter-cyclical sector that moves inversely with the broader market.
- The replacement auto parts company example.
My portfolio’s Beta Coefficient
I gave the search “VCADX beta coefficient” on google and google finance displays the beta coefficient for VCADX so easily that I repeated the same procedure for the remaining mutual funds in my portfolio and here are two tables.
Table 1: Income Portfolio
- Mutual funds that primarily generate dividends, capital appreciation is secondary
- 64% of my passive income streams portfolio is in this category
| Investment Vehicle | 1 year Beta | 3 year Beta | 5 year Beta | 10 year Beta |
| VCADX (CA Munis) | 0.93 | 0.93 | 0.96 | 0.93 |
| VTMFX (Balanced fund) | 0.69 | 0.73 | 0.72 | 0.76 |
| VDIGX (Dividend Growth) | 0.87 | 0.90 | 0.81 | 0.80 |
| VHDYX (Current Dividend) | 0.93 | 0.92 | 0.84 | n/a |
| Average | 0.86 | 0.87 | 0.83 | 0.83 |
Table 2: Capital Appreciation Portfolio
- Mutual funds that primarily invest for capital appreciation, any dividends are secondary.
- 36% of my passive income streams portfolio is in this category
| Investment Vehicle | 1 year Beta | 3 year Beta | 5 year Beta | 10 year Beta |
| VTCLX (Capital Appreciation) | 1.04 | 1.02 | 1.04 | 1.03 |
| VTMSX (Small Cap) | 1.32 | 1.13 | 1.19 | 1.18 |
| VTMGX (International) | 0.99 | 1.03 | 1.02 | 0.97 |
| Average | 1.12 | 1.06 | 1.08 | 1.06 |
Conclusion
Consider the Average beta values for both the income and cap appreciation portfolios:
- Income portfolio
- Average beta is less than 1 => my Income portfolio will be less volatile than the market.
- Capital Appreciation portfolio
- Average beta is greater than 1 => my Capital appreciation portfolio will be more volatile than the market.
Based on the above numbers, I can conclude that when the next recession comes, my Income Portfolio should continue to generate approximately the same amount of income (give or take a few percent) because it is less volatile OR less risky that the overall market.
Humble FI 