Beta, Risk
...and Portfolio Management, oh my!

by George Runkle (TMFRunkle))

Atlanta, GA (July 12, 1999) -- In last week's column, I briefly touched upon beta and risk. This week, I'd like to go a little more into the theory behind this, and maybe help clarify how we can use beta to effectively manage our risk in stocks we pick. Part of the theory behind this is that the market works fairly efficiently, and that all stocks are priced on the basis of all available information. For me, this is hard to believe in all cases, but let's work forward from that assumption.

Digging out my Financial Management text, we find this basic equation:

Required Return = Risk Free Return + Premium For Risk

Going from this, we can use an equation called the Security Market Line:

Ki = Krf + (Km - Krf) * beta

Ki is the required return for the individual stock, Krf is the "risk free" rate of return, generally the 30-year Treasury bond yield, and beta is the amount a stock moves relative to the market. Beta is calculated as the amount of change in price a stock will have relative to what the market is doing. If a stock has a beta of 2.0, the stock will change in price at twice the percentage of the market, in theory anyway.

From here, we now assume that the market is somewhat efficient. In that case, a stock will be priced at any given time to give the return Ki. For betas greater than 1.0 the stock will be required to provide a return greater than the market, for less than 1.0 the stock is required to provide less. This will be reflected to some extent in the price of the stock. Actually, some theorists believe it will be 100% reflected in the price of the stock and that the market is perfectly efficient.

Using this idea, we see that a high beta stock has the potential of a huge return. Amazon (Nasdaq: AMZN), for example, has a beta of 3.45. So, to make lots of money, we just buy high beta stocks, right? Well, I did that as an experiment in my own brokerage account. I did a search for the highest beta stocks, and I found Network Solutions (Nasdaq: NSOL). By the way, Network Solutions does not have a Drip and generally a company has to be a bit more mature before offering one. Until recently, this company had the monopoly on Internet domain name registrations. It had a beta of 7.0 at the time I bought it. I've lost about 1/2 the money I put into it so far. Why is that? Why didn't I get rich?

The reason is the required return. If the 30-year long bond yields 5.50%, and we assume the market returns 11%, guess how much Network Solutions had to return? I calculate 44%! To meet this expectation, it must keep up phenomenal earnings increases over the next few years. When it lost its monopoly on Internet names registration, investors weren't sure it could do that. The price had to go down to a point where it could give the expected return again.

Now, the theory isn't perfect. A stock's beta is based on its past performance, but it won't necessarily behave that way in the future. Network Solutions currently has a beta of 2.52, compared to its earlier 7.0. That helped me in this case, since the expected return went down. However, the beta goes the other way after you bought the stock, it could hurt you more with any bad news.

Also, there is no fixed period for evaluating beta. It could be different if calculated over different periods of time. As I pointed out last week, Texaco (NYSE: TX) has a beta of only 0.44, however it fluctuated over 30% from March until the present. If its beta was calculated during that period, it would be much higher. Finally, I find it hard to believe the market can be totally efficient. We've all seen stocks rise up through the roof because of emotional reasons that have little to do with valuation. We've also seen stocks plummet for a short period of time with no real bad news. Sometimes certain types of stocks just seem to fall out of favor.

However, we can use this as a tool to fine-tune our portfolios. If we want to beat the market, we'll have to chose stocks with a higher than 1.0 beta. This increases our risk, though. If we want lower risk, we can have that with low beta stocks. However, our returns will likely be below the market. In a short-term period, it's hard to predict what the market (and individual stocks) will do. Drops in prices can and do happen, so if we have a very near-term horizon, low beta stocks are advisable. Over the long-term, we can probably safely assume that the market will overcome any corrections it may have, and we can ultimately see gains in our more volatile stocks. In such case, we can take the higher beta stocks with the possibility of higher returns.

To discuss this column and direct investing, please visit the message boards linked in the top right of this page.

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