Beta equals risk. Everyone who has exercised fingers on a keyboard to build a portfolio in Morningstar’s Principia Pro, Advisor Workstation or other compilation software is familiar with beta.
If a benchmark is “1” and beta is .37, it means that, in theory, the risk (and by implication, the volatility) should be about 37% as drastic as the fall of a benchmark, since 1 is 100% of the benchmark. If the selected benchmark is the S&P 500, and it sinks by 100 points, then the portfolio with a beta of .37 might be expected to drop 37 points or so. A beta of 3 would decline three times as much as the benchmark.
Beta relates to modern portfolio theory (MPT), which provided some initial ingredients that spawned the mathematical formulaic wizardry of Robert C. Merton and Myron Scholes, two men who infamously bet the farm that they could manage risk through equations, such as CAPM (the capital asset pricing model). As it happened, they couldn’t, and the two men nearly took down the financial sector, losing something to the tune of $100 billion when their Long-Term Capital Management (LTCM) hedge fund failed. At the time, Warren Buffett, George Soros and others refused
to help. In the end, a consortium of banks saved the day. LTCM is a long-gone goose, but asset pricing remains.
Does beta work?
It worked beautifully for me and for others, during the technology bubble that stretched from March 2000 to March 2003, but not so well during the current credit crisis. Indeed, there’s been plenty of criticism of MPT in recent months; some think it is broken. I’m not sure that it is. I think that maybe what has changed is correlation — asset classes that used to behave in different ways at different times now seem to march in lockstep. MPT stripped down to its basics, simply says that, all things being equal, investors like less risk. CAPM is about pricing risk.
If one has a portfolio of $100,000 that’s a mix of bond funds and low-volatility mutual funds with an overall beta of .37, and the overall market goes south by 40% and the portfolio goes south 26%, there’s something wrong. The normal decline should theoretically be in a narrow range above or below 14.8%; this example may reveal yet another casualty from the new battle of trying to find non-correlating assets.
Restating, beta says that a 40% decline in the benchmark would lose $40,000 if one had $100,000 invested in the S&P 500 index, as opposed to losing about $14,800 if one was in the .37 beta portfolio instead (.37 x 40% = 14.8, or $14,800). If one was in a portfolio with a beta of 1.5, the loss would have been $60,000 (1.5 x $40,000); a beta of 2 would generate a loss of $80,000.
It is interesting to note that if portfolios that had relatively low betas pre-2008 are rerun today, they show higher betas, some by a significant margin. The 2008-2009 credit crisis — which really began the summer of 2007 — has turned things upside down.
What would Warren say?
Mr. Buffett, the world’s greatest investor, doesn’t like formulas, or, for that matter, terms like beta, alpha, vega, delta or rho. He says that investing only requires elementary arithmetic. However, for most investment advisors, beta is a useful tool for determining approximate risk in a portfolio. And, as much as I admire and like Warren Buffett, many investment advisor customers do not think in the long slices of time he does.
Total beta
There is a fairly new risk measurement called total beta, which includes a factor for standard deviation. If an advisor is trend-following, he may need a signal to get out of the market, and total beta may be the way to go; any metric that combines standard deviation and beta sounds like a good idea.
I toyed for a time with combining VIX (the volatility index) with beta to try to determine market exit points, but the trouble with VIX is that it can be a good signal or bad.
High volatility can mean the market is going down, but many forget that it can also mean the market is going up. One man’s exit point could be another’s entry. VIX is interesting to view on a long-term basis. There is much to see about VIX on the Chicago Board Options Exchange Web site, at www.cboe.com/micro/vix/introduction.aspx.
Broker’s Bookcase
Of Permanent Value — The Story of Warren Buffett, 2009 Woodstock Edition, Volumes 1 and 2, by Andrew Kilpatrick (AKPE, 2009). Do you want to know everything about Warren Buffett? If so, read these two volumes, and you’ll even see a copy of his tax return, circa age 13 (income: $592.50, mostly from newspaper routes, with deductions for watch repair and a bicycle, and before Buffett says, he moved into “the big money,” by improving his delivery route to an all-inside complex of apartment buildings).
Also, did you know that Berkshire Hathaway sued the IRS and won? One suit suggested that the IRS collected $16 million too much in 1989 and 1990; a second debated $7 million in regards to 1991 taxes. Buffett won both and the IRS coughed up $23 million, hardly chump change.
As the story above shows, you’ll learn about Berkshire Hathaway, too. Warren Buffett equals Berkshire and Berkshire equals Warren Buffett. You’ll learn about most of the people who played parts in the creation of the world’s most transparent company, and one of its most successful companies as well.
The author has a wicked sense of humor, as does Buffett, which makes for an interesting read and keeps the material lively and interesting. There are 1,971 pages of writing and photographs, but I have never been bored reading any page. The volumes are a great reference to how Berkshire developed and grew into a behemoth that employs something like 246,000 individuals.
Buffett followers will know that there’s another new book about him: The Snowball—Warren Buffett and the Business of Life, by Alice Schroeder (Bantam, 2008). It’s good, mind you, but it seems to have an overarching feeling of angst and sadness. Snowball begins at Buffett’s office for an instant; then moves to an Allen & Company meeting for the super-successful “elephant bumpers,” held in Sun Valley. The book regresses and progresses from there. I’m not that interested in the seemingly internalized information in Snowball. (I don’t care about difficulties with granddaughters, faux or real, and assume most of us stole a pack of gum when we were young and foolish.)
On the other hand, I am fascinated by the minutiae and the why, how and who details that is so readable and complete in Of Permanent Value. Kilpatrick has done an excellent job of portraying Buffett and Berkshire, and it’s amazing that he did it with little access, while Alice Schroeder had six years of virtually unlimited access.
Of Permanent Value is available through Amazon (www.amazon.com), or by contacting Andy Kilpatrick andyakpe@aol.com.
Readers may write to Richard Hoe at Richard Hoe Investments, LLC, 7134 South Yale Avenue, Suite 560, Tulsa, OK 74136, or email him at richardhoe@richardhoe.com. Mr. Hoe has been an investment professional for 40 years, and is a registered representative and investment advisor representative. He has been writing professionally for more than 50 years, and is a member of the adjunct faculty at the California Institute of Finance, a graduate school at California Lutheran University that offers an MBA in financial planning. He holds five designations, including, Chartered Financial Consultant, Chartered Life Underwriter and Accredited Estate Planner.
This information is intended for financial professionals only, not the general public. This is not a solicitation to buy or sell any specific security. Mr. Hoe may have positions in the securities or other investments discussed.