Where you are trying to go — Investment Planning: Investor's CalcStation | How you are going to get there — Portfolio Management: Investor's WorkStation | How well you have done — Modified Dietz Performance Calculator: PerfCalc | What you need to think about, know, do, have, use, forget, and avoid — Investing Principles and Perspectives: In My Opinion | Home | Contact Us | Free 30-Day Software Trials | Prices/Order

Modern Portfolio Theory | Efficient Frontier Analysis | Monte Carlo Analysis

Beta.mp3

 

Mindless Modern Portfolio Theory

Beta

Beta is simply a contrived comparison of the changing relationships between two related but unconnected investing variables (after the fact) to measure the volatility (sensitivity) of an investment in relationship to a selected market index in an effort to predict investment risk as the financial markets change.

When looking into the investment past in a lazy attempt to predict the investment future, investment advisors and investors state that when a selected index has changed in value during a selected time period in the past, the price of a selected investment has been overly, equally, or less sensitive in its price change in the past when compared to the percentage change of a selected index for the same time period in the past.

Investment advisors typically follow with the investing risk non sequitur that because investments in a portfolio have low Betas, the portfolio is less risky than a portfolio with higher Betas; the higher the relative volatility, the higher the Beta, and, therefore, the higher the investment risk and the lower the relative volatility, the lower the Beta, and, therefore, the lower the investment risk.

The unfortunate and powerful allure of the concept of Beta is that it is easy to understand, that it appeals to the individual who is looking for yet another easy way to predict investment risk and investment performance, that it does do not require much analysis, and that it lends itself to simplistic conclusions and dramatic and compelling graphic presentations.

The tragedy of this flawed investing concept is that you must not take the term Beta, translate its derivation to your liking, and apply your misunderstanding of it and an investors' unfamiliarity with it to use as a reason for current investment selection and the basis for predicting investment risk and future investment price behavior.

Beta Assumption

The errors of the concept of Beta begin with its assumption.

One must first blindly accept the premise that price volatility is a measure of, an indicator of investment risk when starting, no falling down the Beta path; absurd, as anyone who has spent more than a nanosecond in the financial markets would, should know.

Before succumbing to this Beta Baloney premise, simply take a random selection of a few equities, review their price histories, their Betas, and draw your own conclusions as to whether price volatility is a meaningful indicator of investment risk - not too long ago, GM: Beta = .75, Google: Beta = 1.08; this example and thousands more like it refute Beta's volatility/risk assumption as a measure of investment risk.

Beta Math

We all have learned how to solve for an unknown if we know two of three variables: A/B=C. The equation is a universal truth and applies in all circumstances when applied to the absolute relationships between numbers:

• if X= 10 and Y= 5 then Z= 2.

• Always true.
  
  
• Given X and given Y as numerical variables in a math class, the mathematical equation, X/Y=Z, is a universal truth and applies in all circumstances when applied to the absolute relationships between numbers; if X = 10 and Y = 5, Z will always be 2.

The Beta of a stock may be determined as follows:

• Beta = [Cov(r, Km)] / [StdDev(Km)]2

• Where: r is the return rate of the investment; Km is the return rate of the asset class.

• Not always true.

Modern Portfolioists have divined this basic Beta equation concept by conveniently assuming that there is an underlying financial system with laws, rules, and relationships as with the science of (near) certainty in the solar system; if a Beta is this and if the market does that, the investment will do this and, therefore, there is little or less or some or more investment risk for the investment when compared to the changes of a selected stock market index; used and said all of the time and simply not true.

Modern Portfolioists fail to understand the differences between the actual relationships between causes, connections, and effects as found in systems verses the randomness of incidences, coincidences, and chances as it pertains to investment variables when attempting to predict future outcomes based on the past relationships of unrelated and unconnected investment variables:

• A Beta equation is not a universal truth and does not apply in all circumstances.
  
  
• The qualifier for this beta equation, as with all other beta equations, which points out the weakness in the concept and the equation to begin with, is, "If the asset class is well chosen so that the return fluctuations of the investment and the class are highly correlated, then the formula approximates the volatility of the investment divided by the volatility of the class." "Well chosen" and "highly correlated?" Who makes that decision and, once made, is it the rule or the exception?

• Ever increasing modifications have had to be made to Beta equations -with the hope of better accounting for the exceptions and for the fact that prior iterations did not work- with the intent of leading new and naive beta believers to conclude that if an equation appears to be complex, it must be valid.
  
  
• The investment past, the variables used to calculate Beta, and the changes of the variables are not actually connected to the investment future other than coincidentally.

• Beta's value for making future investment recommendations depends on the incorrect assumption that the investment past will "probably" repeat itself with the same order, level, frequency, and duration in the investment future as it did in the investment past; however, as with any predictive analysis there must be an underlying order and connection of the variables used in a predictive calculation (not necessarily completely understood and, therefore, a theory) in order for known past and current behaviors, levels, or results of some variables may be validly used to predict future behaviors, levels, or results of the unknown variables in any type of analysis.

Beta, like a thermometer, is merely a numeric term used to measure past relative investment performances between two investment variables and not the cause of either.

Furthermore, if a thermometer also happened to store prior temperature readings on a daily basis, you certainly would not retrieve that information and use it to predict tomorrow's or next week's temperature readings; the same holds true for historical beta readings as a basis for predicting future betas.

As one would have to analyze the weather-changing causal variables that affect weather, such as humidity and barometric pressure, to predict future temperature levels, future investment value and associated risk can only be meaningfully understood and predicted based on one’s correct understanding and interpretation of the performance-changing, causal investment variables that affect an equity’s behavior.

Also, as beta is not causal, to suggest that an investment has been and therefore should be/will be more or less volatile and therefore more or less riskier when compared to another investment/index in the future based on Beta simply does not follow.

Earnings can cause, do cause, changes in equity prices and price volatility.

For this reason we here of earnings alerts, but never of Beta alerts.

The misuse of Beta is also the result of failing to distinguish between two types of investment risk; theoretical investment risk and absolute investment risk:

• Theoretical investment risk, Beta; the relative price volatility of an investment with an index to suggest future investment risk.

• Absolute investment risk; the risk of gain or loss of an investment based on its own structure, fundamentals, and the level of an investment advisor's and/or investor's investing skills and the use of that information.

Advisors and investors often take a shortcut and use (invalid) Beta, theoretical investment risk, to predict absolute investment risk.

It also most certainly cannot be concluded or predicted that just because an investment is more volatile than another investment that its absolute investment risk, the risk that counts, is greater than a less volatile investment.

Both volatile investments and less volatile investments have performed well and have done poorly.

Furthermore, who cares what the Beta of an investment is?

When an investment is going up the investor only cares about making money and Beta is of no concern to anyone.

When an investment is declining in value while the stock market is plummeting to the earth, all that can be said, if the beta is correct, is that the investment probably will spiral towards the ground faster or slower than the Beta-associated index while the investor only cares about the loss of capital and the action that is going to be taken to prevent further capital erosion.

Finally, Beta is the perfect investment advising, no-fault excuse for investment advisors who are not prepared to assume the responsibility for using their own investment judgment and of applying their own investment skills when faced with an investment setback; It's not my fault that you are down 50%, Beta did this to you!

Investment advisors, get over yourselves with regard to your throwing around MPT terms as an indication of your investment advising expertise and as if you are offering investment insight.

Investors, any type of Beta evaluated portfolio is a reminiscence of past investment events and offers you nothing for the investment future.

Beta and related terms are simply relative measurements; not entirely unlike absolute measurements of distance, height, density, and speed.

None of them predict anything!

It can only be concluded that Beta is an investment crutch for the investment advising and investor weak who are unwilling to do their investment homework and who need a poor investment performance excuse for those who have been wrongly given or who have taken a false sense of investment security by relying on Beta to bail them out.

If you still like, believe, and trust in Beta to determine, predict, or project investment risk, you will love the concept of Ateb (Beta spelled backwards).

• You might want to suggest that doctors apply the concepts of Ateb in their profession as you apply Beta in yours to use historical percentage changes in weight and height over a selected time period to determine the historical relationship between weight and height expressed as Ateb and then to use Ateb to predict future changes of an individual's weight or height when one of those current or future variables and the historical Ateb are known.
  
  
• Weight and height somewhat go hand in hand; at least as much as "r" and "Km" are connected in the formula shown above to calculate Beta.
  
  
• The formula for calculating Ateb is much like the formula for calculating Beta.
  
  
• You can keep your formula simple:

  Percentage change in weight over a selected time period = Ateb
  Percentage change in height over a selected time period

• During one historical analysis period it was determined that an individual's weight went up 50.lbs; a 25% change.
  
  
• It was also determined that during the same time period that the same individual's height increased by two inches; a 10% change.
  
  
• Therefore, using our Ateb formula by dividing 25% by 10%, Ateb is equal to 2.5.
  
  
• Therefore, knowing that Ateb is equal to 2.5 and that it has been predicted/determined that at a future time period the individual's weight will or has increased by 20%, the application of Ateb translates into a the prediction/conclusion that the same individual will have a 8% change in height.
  
  
• Want to grow taller still, eat more Ding-Dongs.
  
  
• In fact, if the individual loses weight during an analysis period, the loss in height can also be predicted!