The Power To Perform: mhj3.com Managing Investing Judgment Since 1989

Investing Fool's Tool #4: Beta Baloney
To beta, or not to beta: that is the question.

Think about it: 'Past investment performance is not an indicator of future investment results' is a required, responsible, and absolutely true investing footnote, an investing fact that anyone who has spent more than a nanosecond in the financial markets would or should know, and an investing law designed to protect the investing naive, innocent, and unsuspecting.

Then why would one blindly place his/her trust in the present and his/her hope for the future in a mythical investing science — Modern Portfolio Theory and all of its illegitimate relatives such as Monte Carlo Analysis, Efficient Frontier Analysis, Beta, Brinson's Asset Allocation, Pie Charts, and a distant relative, Technical Analysis (worth a glance) — that relies solely on past performance investment data to feed hypothetical and contrived investing algorithms in a misguided effort to predict future investment results?

All are just other ways to record and to illustrate investment history without valid analytical, interpretive, deductive, predictive, or directional investment value.

If this nonsense were valid, there would be no need for investing analytics, forecasting, or guidance of any kind — research, analysis, opinion, advisors — and one would simply select investments based on past performance without regard to suitability, quality, structure, or risk.

Explained another way, a thermometer measures temperatures in degrees as the weather changes.

A thermometer is a recording device not a forecasting one and, therefore, it cannot be used to predict future temperature levels.

Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio are much like a thermometer; merely means to measure past (contrived) relative investment performances between investment variables and neither the cause of nor the predictor 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.

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.

The same holds true for historical Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio readings as a basis for predicting the investing future.

Future investment values and associated investment/investing risks can only be meaningfully understood and predicted based on one’s correct understanding and interpretation of the fundamental performance changing, causal investment performance variables that actually affect an equity’s behavior.

Keep in mind, there is no theory — modern or otherwise — that can be ordained, no computer that can be programmed, no software that can be designed, no investing tool that can be 'imagineered,' no technical analysis voodoo methodology that can be contrived, and no equation that can be divined to quantify, evaluate, and predict the primary forces that drive the sublime chaos of the financial markets and investment prices; human consensus, mood, and behavior; intelligent and not, knowledgeable and not, reasoned and not, rational and not, and logical and not.

Beta

While confusing the concepts of 'connection' and 'coincidence,' Beta is simply a contrived numeric comparison of the changing relationships between two related but unconnected investing variables (after the fact) to measure the relative volatility (sensitivity) of an investment in relationship to a selected market index as both oscillate over time in an effort to predict an investment's current/future risk as a linked market index changes over time.

When looking into an investment's past performance in a lazy attempt to predict an investment's future performance, investment advisors and investors typically and naïvely 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 an investing risk non sequitur that concludes that because investments in a portfolio have low Betas, a portfolio, therefore, is less risky than a portfolio with higher Betas — the higher the volatility of an investment relative to a selected index, 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 for the investing unsuspecting 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 not require any/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 misguided and misleading core assumption; one must blindly accept the premise that historical and current investment price volatility is a measure of, an indicator of current and future investment risk when starting, no falling down the Beta investment risk and investment performance path; absurd, as anyone who has spent more than a nanosecond in the financial markets would, should know.

Modern Investing Math Mystique

There is an ever increasing and unexplainable modern investing math mystique investing equation phenomenon; if what seems to be or is defined to be a cause and effect occurrence expressed as a mathematical equation, the equation is assumed to be, must be valid, universally true, and has unique predictive powers.

'Einstein's theory of relativity seems to be valid:'

'Certainly If is valid and reflective of actual cause and effect variable relationships and is, therefore, predictive of behaviors in the universe, then surely the latest iteration of the Beta risk measurement equation below — much more complex, with many more variables than Einstein's equation — most certainly, must be, just has to be valid.'

From:

Beta = [Cov(r, Km)] / [StdDev(Km)]2

To:

'Wow, look at this one, honey.'
'It just has to work!'
'Let's put all of our life savings into this equation!'

Well, it doesn't.

Regrettably, mathematicians concluded that since Einstein's simple math works in the universe to explain current natural phenomena and to predict future relationships and events, it most certainly will work in the sublime chaos of the financial markets.

A few Albert Einstein mathematician wantabes, while ignoring the obvious structural and causality differences between the universe of nature and the universe of the financial markets, extracted the laws and concepts of Einstein's universe, so to speak, and attempted to superimpose them, in effect, onto the world of investing by confusing, comparing, and applying the concepts of immutable order, structure, relationships, causes, connections, correlations, effects, and rules (Newton's three Laws of Motion, for example) as found in the sciences and systems of the universe — and as explained with mathematics — with the chaos, incidences, coincidences, chances, correlations (none of which are causal; but, assumed in order to make Modern Portfolio Theory math work) and no rules as found in the artistry and complexity of investing and managing capital in the financial markets in an effort to predict investment outcomes; the ultimate 'non sequitur' of investing.

The popularity of modern investing math can be explained by the facts that no investment advising or investing skills, insight, or foresight are required — just define, retrieve, sort, select, present, buy, and hope that the investing past will somehow be the investing future — and the investing naive and unsuspecting are easily mesmerized by and respond to the apparent wizardry of the pie charts, graphs, and data dumps that modern investing math can generate.

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.
    • Given the relationships of the underlying variables that generate Beta equation variables — both of which are defined as being connected but actually are only coincidentally related — conclusions will be nothing more than coincidental and will have no meaningful/reliable predictive value.

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.

Beta Realities

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 vs. Thermometer

Explained another way, a thermometer measures temperatures in degrees as the weather changes. A thermometer is a recording device not a forecasting one and, therefore, it cannot be used to predict future temperature levels.

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.

Beta and Theoretical vs. Absolute Investment Risk

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.

Betafied Investment Advisors

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 investing judgment and of applying their own investing skills when faced with an investing 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.

Beta/Ateb

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 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 first 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 pounds; 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 40%, the application of Ateb translates into a prediction/conclusion that the same individual will, therefore, have a 16% 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!