BUNK 19
BETA MEASURES RISK
Stocks are risky. Simple fact! But to get return, you must take risk—which many folks feel as volatility. (See Bunk 6.) Volatility is uncomfortable near term for most folks and quite unpredictable—and makes investing even harder than it might be otherwise. Makes many go mental—drives ’em nuts, pure and simple.
Because people are prone to like order, we like to measure. Take beta, for example—the academic concept, widely accepted throughout media and the investing culture, that claims to measure investment risk. Take it outside and leave it there. It’s useless. No—less than useless.
Folks (particularly academics who first foisted beta on us) like to think beta measures risk. No—it measures prior risk. It measured risk—past tense! It doesn’t measure anything about the present or future. Beta itself is a simple and accurate calculation. A stock’s beta is a number representing its past volatility relative to the overall market’s past, over a specific period. The higher a stock’s past volatility, the higher its beta. If a stock moved perfectly in line with the overall market (usually in calculating beta, folks use the S&P 500 as the market index—but beta can be calculated against any market index), its beta is 1.0. Lower, and it was less volatile than the market; higher, and more so. Simple enough.

Past Performance Is Never Indicative of Future Results

Academics first presumed, contrary to centuries of common sense and without any sound reasoning, that if a stock has been more volatile than the market, it is therefore more risky going forward. The academic world therefore proclaimed beta to measure a stock’s risk. While there is no actual evidence of that, ever since, way too many investors believed beta reflects future risk, despite hearing and knowing that past performance isn’t indicative of future results.
Belief in beta has made folks do all forms of nutty things. Nervous Nellies want only low-beta stocks and low-beta portfolios. Let me give you a simple example of this folly (one I wrote about in my second year as a Forbes columnist—“Witch Doctors,” June 2, 1986). Take a low-beta stock and have it drop by 90 percent over two years. The beta will go through the roof. Is it now higher or lower risk than before the drop? Well, it can’t be higher on any rational basis, but beta says it is. So if you believed beta, you believed once-upon-a-time hot cosmetics maker Avon was relatively low risk with a beta of 0.9 at $120+ in 1973, but high risk the very next year at $19 after an 85 percent drop—with a beta of 1.3. Intuitively, the risk for Avon as an individual stock must have been higher at $120 in 1973—before the monster stock price drop—than at $19 in 1974. Buying after any big drop relative to the market means buying a higher beta, but is one traditional way to look for potential lower-risk bargains going forward.
Another way beta makes folks’ brains go haywire: Those who believe more risk means more return (in a sense they’re right) have bought into the popular notion that the only way to beat the market is by taking extraordinary risks via high-beta stocks—but then they screw up by using beta as a screening tool. Because beta is a purely backward-looking phenomenon and isn’t predictive going forward, buying a group of high-beta stocks doesn’t give you a low-risk /high-return approach. This is like driving while looking in the rearview mirror. It’s destined to be problematic.
Here’s some irony. Academics understand well that stocks are non-serially correlated. That’s statistical talk saying—in plain English—price action alone tells you simply nothing about the future that’s exploitable. Study after study shows that to be so. Yet academics early on bought into the notion that past volatility (which is based solely on price action—which they know is non-serially correlated by definition) is somehow useful. How wrong!

Categories That Fall Most Bounce Most

Think this through another way—and one that can be statistically measured to happen around all bear market bottoms: If you could perfectly time a bear market bottom (which you can’t, but this helps illustrate why beta is silly) and invest more heavily in those categories that will perform best over the next 6 and 12 months—would you want to? Of course! But you couldn’t if you used beta to manage risk. Let me show you. First: Overall risk going forward, by definition, is actually lowest immediately after the bottom of a major bear market. (Of course, again, we don’t know with certainty just when that is.)
You also know from Bunk 9 that bear markets end and bull markets begin in a V. The bigger the end of the bear, the bigger and faster the initial bounce off the bottom—which is just part of what makes timing bear market bottoms so tricky. But then comes another common characteristic of bear market bottoms—one that isn’t widely understood, but one my firm demonstrated a long time ago statistically across the span of the history of bear markets.
Those categories that hold up better than the market during the beginning of a bear that then fall the most in back of a bear market (making them high-beta) bounce most in the early stage of the new bull. Figure 19.1 shows this almost perfectly for US stocks—showing sector performance six months before the March 2009 bottom (the dark bars) and six months after (the lighter bars). The sectors that fell most to the bottom then, in fact, had the biggest returns post-bottom. The parallel isn’t perfect but is almost perfect any way you cut it (what in statistics is referred to as a near-monotonic display and in history is consistent across bear markets).
And because US and non-US stocks can be highly correlated, you see the exact same effect globally in Figure 19.2.
Those categories with the best returns after the bottom had the biggest beta at the bottom. They had more volatility to the bottom and more volatility than the market in the new bull! But the way our brains work, we tend to think: When it’s down, it’s “volatile,” but when it’s up, it’s “good”! So if you were using beta to manage risk and wanted to avoid “risky” high-beta stocks, you missed the categories that performed best!
Figure 19.1 What Falls the Most Bounces the Most—US Stocks
Source: Thomson Reuters, S&P 500 price return from 09/09/2008 to 09/09/2009.
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Figure 19.2 What Falls the Most Bounces the Most—World Stocks
Source: Thomson Reuters, MSCI Inc.,1 MSCI World Index price return from 09/09/2008 to 09/09/2009.
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Don’t take that to mean a high-beta stock or category is always going to have outsized returns going forward. No! It just means it was measured by beta to be riskier than the market at the bottom of a bear market, looking backward. It fell more. It says nothing about whether it will be riskier going forward. Sometimes, in some markets, stocks that lagged the market badly (i.e., had high betas) catch back up and become low beta later. Or high-flying stocks (also high beta) fall back to earth and stagnate. Beta is illustrative of what a stock has been like—not what it will be like. Trying to manage risk or enhance performance through beta alone is a fool’s errand. Beta doesn’t measure risk; it measured risk—and investors should always look forward, not back.
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