WARNING! Don't Take Beta-Blockers To Reduce Your Portfolio's Volatility

by: Peter F. Way, CFA

"Modern" Portfolio Theory [MPT] back in its inception years of the '60's, branded that part of a stock's price gyrations in excess of "market-average" fluctuations as "beta" to differentiate it from the stock's systematic outperformances of the market-average price trends, which was labeled "alpha." Pretentiously very scientific.

Elaborate measurement procedures, all speciously-based on "Normal Statistics" wound up labeling beta as the "risk" element of individual securities. The academic-excuse-watchwords were "price volatility is a proxy for risk."

Specious on two counts, since 1) volatility is in reality a measure of uncertainty, an aggregate that contains both potential upside and downside price variances, both risk and reward, inversely, depending on the investor's posture as being either long or short the subject investment vehicle, and 2) for Normal Statistics to be properly applied, there must be reasonable evidence that the true state of nature of the thing being described fluctuates in a normal pattern. Even at the time that MPT was being propounded it was well-known that securities prices, particularly in equities, deviated quite significantly from the "normal distribution."

But to be able to pursue the pretense of a scientific approach to securities pricing and thus portfolio management of risk and reward, this "slight" fatal flaw had to be ignored, since at the time there appeared to be no way to separate uncertainty into its two opposite components, let alone identify their potential asymmetry.

The conventional doctor-of-investment diagnosis for reduction of risk became the prescription of seeking out stocks that had minimal volatility, or beta, for portfolio emphasis. Hence, the Beta-Blocker approach. Then, to achieve returns, the search turned to find high-alpha stocks, the ones that were out-growing the market's trend.

"Growth stocks" were the prize targets. Until it became evident a decade or three later that the pesky black swan deficiency of the normal distribution made it impossible to reliably tell by MPT procedures what really had continuing market outperformance capabilities.

Worse yet, choosing to emphasize low-beta stocks meant struggling with minimal reward opportunity vehicles that could not regularly keep up with market averages that contained high-beta components, which competitors could disproportionately utilize in their clients' portfolios.

Finally, the risk roof caves in on buy-and-hold managers. Ones who deprive their clients of the opportunity to capture the positive price fluctuations of high-beta stocks during their favorable periods, and the avoidance of those, and other, stocks during the unfavorable periods. But horrors! To do otherwise would mean taking a "timing" approach! Now we're talking speculation, not investing!

The investment dinosaur procedure of not recognizing how the civilized, social, technological world is changing around them puts the investors subjected to that approach at a considerable risk, just outside of their view. But not out of the view of those who stay abreast of the changes in communications, competition, and market regulations (or effective lack thereof) that now control the world around us all. Such failure to recognize change, and insistence on believing expectations reaching several years into the future can be reliably forecast, is the true speculation.

We believe we have special insights into how to systematically deal with risk and reward. We are not alone. Many progressive investment managers have found ways to employ changes in communications, in markets, in securities types, and in thinking, to more successfully compete, at the expense of those who don't. For many, investment survival will be at issue.

One of the more dramatic changes that an investor can make is to shift from the assured, complacent, "conservative(?) long-term, buy, hold, (and forget) investor" posture that has been broadly and persistently espoused. Move instead to the approach of being an active investor that is constantly reappraising what provides the best current outlook for all of the holdings in the portfolio, continually weeding out the current weak when they can be replaced by more robust vehicles.

Active investing means more work, consuming discretionary time, and making activity trade-offs that are difficult. But it should provide future advantages that would be impossible to achieve, once the time has slipped by. Deciding how one and one's dependents want to live, and what are appropriate activity and time prices to pay are difficult and evolving needs, but are planning, essential to maintain.

Additional Disclosure: The author has an investment interest in the website blockdesk.com which, while not yet open to the public, is in conversion from being a delivery medium of information to institutional investors to a new life of providing similar help to do-it-yourself investors. Both brief and extended-time subscriptions for single or multiple issue inquiries should be at quite reasonable and manageable costs for individuals. Announcement of its opening is hoped for in the 4th quarter of this year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.