What to buy in times of war

The spectre of war has not been far from the front pages over the past year. Last summer, the big fear was over the US reaction to a nuclear North Korea. Now the biggest concern is that the West will end up further entrenched in Syria, or worse still, that the violence and confusion in that country will trigger a larger battle between the various parties currently in the region. That's not a pretty thought.

The one piece of good news, however, is that if nothing else, you probably don't need to worry too much about what it means for your portfolio. That's because, as Mark Armbruster of the CFA Institute notes, a review of market reactions during the major wars between 1926 and 2013 shows that the impact of war on US stocks was perhaps strangely largely positive, rather than negative.

World War II, the Korean War, Vietnam and the first Gulf War were all periods in which "both large-cap and small-cap stocks outperformed" their long-run averages (although the final war on that list was extremely short compared with the others). Perhaps more surprisingly still, volatility did not take off (in other words, prices didn't seesaw dramatically) indeed, markets experienced lower volatility than normal.

Bonds, however, "generally underperformed". Armbruster points to two main reasons for this. Firstly, war tends to be inflationary, and bonds do not like inflation (most bonds pay a fixed income, whose value dwindles when inflation rises, driving the price of the bond lower to compensate). Secondly, governments tend to borrow more during wartime. That means more supply, which again tends to drive prices down. In other words, if you're feeling nervy about the prospect or possibility of war, then, strangely enough, you're better off avoiding the traditional safe haven of bonds.

However, one safe haven that does do well in times of war is gold. Recent academic research has found that the yellow metal really is a good hedge against geopolitical upheaval. Last year, two Federal Reserve economists, Dario Caldara and Matteo Iacoviello, created a Geopolitical Risk Index by searching major global newspapers for words related to geopolitical tensions and events put simply, the more bad news in the press, the higher the risk index. According to Dirk Baur of the University of Western Australia Business School and Lee Smales of Curtin University Business School, the index has a "positive and highly significant relationship with gold", notes Citywire in other words, when it goes up, so does gold, and vice versa. We've always suggested that you have a bit of gold in your portfolio, in case of emergencies. This finding only confirms that view.

I wish I knew what alpha and beta were, but I'm too embarrassed to ask

In very simple terms, alpha is the amount of value a fund manager adds or takes away from an investment portfolio. In other words, it measures how their stock- or asset-picking skills affect the portfolio, above and beyond any returns that are simply down to the expected performance of the market as a whole (also known as beta).

Alpha can be looked at in two main ways. The first is simply to compare performance with a benchmark index. So the returns on a portfolio of UK shares might be compared with the returns on the FTSE All-Share index over a given time period. If the manager's portfolio has returned 15% compared with 10% for the benchmark, then the manager could be deemed to have generated positive alpha of 5%.

The second, more in-depth, way of looking at alpha (sometimes known as Jensen's alpha) takes the risk profile of a portfolio into account, and compares its risk-adjusted returns with what a financial model (specifically, the capital asset pricing model, or CAPM, which we won't go into here) would predict it should achieve. So if CAPM predicts a portfolio return of 8%, but the return is 10%, then positive alpha of 2% has been achieved.

Beta is a way of measuring the risk of a share or a portfolio compared with the risk of the market as a whole. In effect, it's a measure of volatility how much a share price bounces around or moves up and down over a period of time. A share with a beta of one will move roughly in line with the stockmarket. A beta of more than one suggests a share is more volatile than the market, while a beta of less than one indicates a share that is less volatile than the market. Traditionally, defensive companies such as utility stocks tend to have lower betas, whereas riskier technology firms or high-growth smaller companies have higher betas.