By DAVID MOON, Moon Capital Management
Being from Alabama, when I hear
someone use Greek letters or words I immediately think of one of those famous
Greek cities, like Rome or Leningrad. It's just so easy to impress most people
with fancy-sounding words that don't have everyday meanings. When my doctor
talks of bregmata, I immediately know it's serious. It sounds serious, even
though it only means the tops of our heads.
The investment industry does the
same thing. We use ten-dollar words to describe interesting theoretical concepts
that often have (at best) limited practical application. Every time I hear
someone talk about the 'beta' or 'alpha' of a stock, I am reminded of how
professional investment folks simultaneously act silly and pompous.
Here is a 20-second lesson about
beta. (It's far from being a complete or perfect definition, so I hope not to
receive too many emails from my friends in academia.) If we look back over some
historic period, we can measure the volatility of the price of a stock compared
to the S&P 500. We call that relative volatility beta. If the price of Acme,
Inc. tends to increase only eight percent when the S&P 500 goes up ten
percent, we say that Acme has a beta of 0.80. When the S&P declines ten
percent, Acme would be expected to decline only eight percent. A more
volatile stock, like International Widget Co. is more volatile than the S&P
500, say by 30 percent. We say it has a beta of 1.3.
One supposed usefulness of beta is
that an investor can construct a portfolio to match his preferred risk level by
using betas to select groups of stocks that will be more or less volatile than
the S&P 500. The problem, however, is that beta is a historic calculation
and doesn't predict the future.
Let's assume that in January 2000
you knew that the stock market was about to peak and you wanted to construct
your stock portfolio to prepare for the likely decline. You still wanted to own
stocks, just in case you were wrong, but you wanted to own things that would
decline less than the S&P 500. So you bought low-volatility stocks like
Reader's Digest (beta of 0.80) Tootsie Roll (0.65) and Kellogg (0.80.) You
bought more than 130 stocks with an average portfolio beta of 0.73. You were
ready for the decline. And you were right; in the next three years, the S&P
500 declined 38 percent. But instead of declining only 28 percent (73 percent of
the S&P 500 decline), your portfolio also declined 38 percent.
You are disappointed, but unwavering
in your commitment to beta. By January 2003, you're convinced that the market is
about to turn around, so you want to own stocks that are going to perform better
than the S&P 500 during a bull market. Value Line tells you that in January
2003, there are 585 stocks with betas greater than 1.15. You buy 470 of them.
Once again, your market prediction is correct. But over the next two years, your
supposed high-volatility portfolio only matches the S&P 500 return of 42.7
percent. Once again, beta fails you.
Your 470 stocks included high-tech
businesses like Microsoft, Oracle, Hewlett-Packard and Nokia. You also owned
brokerage firms like AG Edwards and Charles Schwab, which you might have
expected to perform well during a bull market. But each underperformed the
S&P 500 during those two years ' and each had betas exceeding 1.15. Ten
percent of the high beta stocks actually lost money during this bull market. A
number of the other companies went bankrupt.
There are several reasons that
advisers and brokers use beta when dealing with their clients. Its usefulness is
not among those reasons.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).