What is beta? You can’t afford the answer.

by JT McGee

What is beta?Beta. It’s a scary word, man.

There’s a reason that investors have a tendency to fear beta—have you ever seen a fish fight? Betafish mess other fish up on a daily basis.

So beta’s going to mess up your portfolio, homie!

I’m Just Kidding

Beta isn’t anything to worry about. In fact, beta is a term that finance makes up for self-importance. This is what happens when you hire really intelligent people to manage money; they make it too hard for their own good.

You see, beta doesn’t really mean all that much. It’s just the implied volatility of a specific investment relative to the broader market index, the S&P500 index. When you realize what beta is, you realize why it really doesn’t matter.

If the S&P500 index goes up 2% one day, and down 2% the other, while your portfolio goes up 3% one day, and down 3% the next day, your portfolio would have a beta of 1.5. It’s 50% more volatile than the S&P500 index. (Simplified, but not Dave Ramsey-style. I didn’t lie to you.)

And what does that mean?

Nothing.

Low-Beta is Expensive!

Reducing beta in your portfolio is expensive. If we put half your portfolio (with a beta of 1.5) in cash, we can say that your portfolio now has beta of .75.

We isolated out the risk! You’re safer, happier, and now you can sleep better!

Except that there’s a problem. You know how much money you earn by keeping your money in cash? I’ll spare you the tears—cash has a negative yield. It’s guaranteed to lose money.

So, rather than concern ourselves with the make believe problem that a volatile portfolio is a bad thing, we decide that we should trade volatility for guaranteed loss. Doesn’t that sound better? I mean, with the high beta portfolio you were holding a zig-zagging portfolio. With a low beta portfolio, you’re holding half your investment portfolio in an asset that is guaranteed to lose money, and the other half in that zig-zagging portfolio.

Before: You were either way up or way down on a daily basis but you are likely to manage a positive return in the long-run.

After: 50% of your money is losing value every day, guaranteed.

Rock on!

But that’s not all, folks. Nope.

Mutual Fund Manager’s Secrets

The people who sell mutual funds are infinitely more intelligent than the people who manage the portfolio. They’re brilliant.

They’re really good at hopping on keywords that get people all giddy inside. “Dow Jones” is a great one—Betterment used to sell the Dow Diamonds ETF (and they even called the Dow an index!) but they backed off.

They’ll still screw you on the 1-3 year Treasury ETFs, though. At the very best the 3-year US Treasury yields <.4% and Betterment charges .5% to manage your money. Guaranteed loss to inflation plus a guaranteed loss to fees! People flipped when they heard that they might have to pay debit card fees. Betterment charges you a fee to help you lose money and it’s the most highly-praised thing on the net! Crazy.

But they’re not the worst offender. Nope. Check out this nonsense from the Hennessy Balanced (HBFBX) mutual fund, which duplicates the “Dogs of the Dow” strategy. It stays “balanced” by keeping half your money in cash equivalents, and another half invested in a dubious investing strategy that is the Dogs of the Dow.

Worst mutual fund fears beta.

So, basically, you contribute $2, $1 of which goes into 10 of the worst performing Dow stocks with the best yield. The other $1 stays in cash equivalents, earning you what amounts to basically 0% per year. Tack on inflation and the returns are negative.

What do they charge you for this awesome asset management? 1.65% per year!

Insane! To think that for every $2 you invest you get $1 of equity exposure and $1 of fixed-income money losing exposure which is then expensed at 1.65% per year is pure insanity. People eat that stuff up though.

You can’t afford to care about beta

I continue to say that the biggest risk is not that you’re taking on too much risk, but that you’re taking on too little. Not only that, you’re wasting precious space in your beloved retirement accounts by buying funds that hold cash. It just doesn’t make sense to have cash in a 401k or IRA if the investment universe is (I contend that it is) bigger and better than money losing investments.

The problem is that most people get fooled into caring about beta until they’re too old to realize their error. At this point, they have to care about beta because a minor fluctuation in their portfolio value affects the point at which they can retire.

So, if you have 10 or even 20 more years to retirement, please stop caring about beta. Total returns should be the sole objective as the ups and downs along the way are, at the time of retirement, about as important as what you had for lunch 45 years prior. If at any point during retirement you obsess over the avenues which brought you financial freedom I think it’s safe to say you’re doing it wrong.

{ 12 comments… read them below or add one }

101 Centavos November 9, 2011 at 06:37

How about a REIT with a beta of 0.60 yielding 7% ?

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JT November 9, 2011 at 08:35

MNR?

That’s a pretty fat yield.

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20's Finances November 9, 2011 at 07:26

I agree that some of those fees are outrageous! Great article – I’m still a newbie when it comes to the stock market.

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JT November 9, 2011 at 08:36

The fees are outrageous. There’s no reason to buy a “balanced” fund that keeps half it’s assets in cash when you could buy half as much of an aggressive fund and keep the remainder in cash yourself. Then you don’t even have to pay the fee on the cash!

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PKamp3 November 9, 2011 at 10:18

Considering that the Dogs of the Dow is usually a ten stock trade.. rebalanced annually… that’s probably the worst value I’ve ever seen in an investment. You’d be better off with half your money under your mattress and one trade a year on the first trading day.

Beta is a joke. Alpha, too. The only aspect of alpha I care about is the excess return, because most ‘risk’ measurements are a joke, IMHO. Risk is not taking on enough ‘risk’ when you’re young and running out of money in your retirement. Your career already *is* like a (mostly) risk-free bond – periodic payments for a lifetime of work.

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JT McGee November 10, 2011 at 10:56

What about Gamma? Maybe you just hate Greek letters!

I’m kidding. And I totally agree with your employment being a substitute to a fixed-income security. That concept has slowly trickled through the financial planning community, which, I think, is a good thing.

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LaTisha November 10, 2011 at 08:55

You beta back off my Betterment! lol I’m up 6% so far, not bad for a low fee ETF purchase plan. Then I have a stock with a beta of 2.5 in my IRA. Am I crazy? Yes! But I love it! The stock market always goes up, right?

(Sorry, I must have taken a silly pill today. I can’t possibly be serious today.)

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JT McGee November 10, 2011 at 10:54

Fidelity/TD Ameritrade/Schwab have much better ETF deals. Commission-free, no fee (other than from the ETF sponsor, of course.)

Yeah–ha, it always goes up! I don’t think any more or less of a company based on the beta if I’m buying the equity.

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LaTisha November 10, 2011 at 16:56

But what about the minimum initial investment? Some of those brokers require more than what the ‘target Betterment customer’ is able to put in. It would be interesting to compare their competition. And I bet that once they start growing big enough to draw business away from the other guys we’ll start seeing some ‘comparison’ commercials.

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JT McGee November 11, 2011 at 12:43

Good point on initial investment. I don’t know, as I’m not too big on ETFs, and I use InteractiveBrokers unless I get a good offer for free trades from another broker.

I really think Betterment creates “value” by making investing easy, although I don’t think their tools are adequate, nor do I think that the individual investor really gains by using them.

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Darwin's Money November 10, 2011 at 21:58

I like undestanding and using Beta here and there. To me, beta is a multiplier of returns compared to an underlying index. For instance, tech stocks are typically higher beta than the S&P500 while old economy stocks, utilities, etc. are lower beta. When the market’s hot and everyone’s plowing money into it, you want to be in high beta stocks. This is what I did in 2009. I loaded up on Apple, Baidu, Netflix and a bunch of other volatile stocks and they did great. However, I used to do these monthly portfolio updates at my blog. While I might have “beaten the market” with a return of 12% in a given month compared to the S&P500 return of 4% for a given month, I used to be sure to point out that I was holding high Beta stocks so my return was not that much to brag about. Likewise though, you don’t want to be holding all high beta stuff during a mass market selloff. I dunno, I rely on the measure and the term somewhat routinely; as long as people understand what it means, I find it to be useful.

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JT McGee November 11, 2011 at 12:44

Yeah, I mean, beta is a useful tool for “risk-on” and “risk-off” trades when you want to make cash on the money flow data. BUT! I don’t think it’s a particularly good measure of actual risk.

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