beta

Assuming one's portfolio is well diversified such that the unexpected misfortune of one company is generally offset by the unexpected good fortunes of another company, then the changes in overall portfolio value are generally related to the overall economy. This is because all companies' fortunes are somewhat related to the economy (in the short-run) and when the economy suffers, almost all the companies' business prospects face a headwind. Although when this happens, there will always be a few companies that perform well in spite of the economy, due to some random circumstance, but there is no way of knowing ahead of time which companies will do so.

Beta is simply a measure of how much the portfolio value correlates with the overall stock market, which in turn reflects market participants' expectations for the overall economy. For instance if your portfolio beta is 2.0 and the stock market appreciates 10% one month, then statistically speaking based on historical performance, your portfolio value is likely to increase 20%. If your portfolio beta is 0.5, then your portfolio value is likely to increase only 5%. So what? Well, if the economy is sucking wind and you're therefore at greater risk of financial distress in your own life (job loss, etc), that is the worst possible time for your portfolio (savings) to lose value. So, if one chooses to invest money in stocks that they can't stand to be without for at least 10 years (even during a stretch of unemployment) - which no competent financial professional would ever advise - one should at least avoid constructing a portfolio that will compound the problem by being overly sensitive to the economy.

Now, conventional financial theory asserts that if all investors view the world as outlined in the preceeding paragraph (i.e. all investors are rational), then they will be less attracted to stocks that are overly sensitive to the overall stock market / economy. This collective aversion to 'high beta' stocks, will cause those stocks to fetch lower prices, even if these more volatile companies' future business prospects are equal to the business prospects of 'low beta' stocks/companies. And if one pays less now for a high beta stock (vs a low beta stock) and that high beta stock nevertheless achieves average long-term profit growth equal to the low beta stock, then the investor will end up with a higher investment return (because in the long run, stock price appreciation tracks the company's profit growth).

Sounds great, right? If one can do without their savings for a long enough time period to ride out economic cycles, then one can collect a premium investment return by purchasing high beta stocks and constructing a portfolio with a high average beta! Trouble is, it doesn't work because investors are not 'rational' in the sense outlined above. Rather, people are more concerned with keeping up with the Joneses when the stock market is appreciating than they are with protecting themselves from a declining portfolio value when the economy inevitably falters (after all, it's not so bad to lose money so long as their friends are also losing money). Therefore, investors pay no heed to a stock's beta when deciding whether or not the stock price is attractive. If anything, an investor will pay more for a stock with a high beta, based on a presumption the overall stock market is going to rise and the high beta stock will therefore outperform (which of course it likely will in the short-run, if the investor's prognostication for the overall stock market proves correct). Wouldn't that same investor be fearful of underperformance if the overall stock market declines? Nah, Mr. or Ms. Investor wouldn't buy stocks at all if they thought the overall stock market was about to decline.

So where does that leave us? Why does our model portfolio contain stocks with low betas such that the average portfolio beta is only .79 (as measured against the S&P 500)? It gets back to 'addition by subtraction'. If investors are overpaying for high beta stocks, which represent companies whose profit growth will ON AVERAGE IN THE LONG RUN (the best caveat EVER!)not be any better than low beta stocks, then those high beta stocks will provide a lower long-term return (again, because long-term stock prices track profit growth). Obviously, we want to avoid owning stocks that will underperform due to this factor.

For more on the dynamic outlined above, I highly recommend a new book by Eric Falkenstein called Finding Alpha (which is where I learned about this - thank you, Mr. Falkenstein). I would say the book is a little advanced for anyone not previously acquainted with finance, but it's so full of knowledge and well written, I think anyone who has in fact had an introductory class in finance (or read up on basic finanical theory themselves) would be able to learn something from this book even without understanding each and every page. But I recommend first watching the free videos before deciding whether or not to spend money on the book.