Market Needs Beta Blockers

By DAVID MOON, Moon Capital Management
May 22, 2005

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).

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