High Beta Stocks: Do They Offer Higher Returns?

Jan.31.07 | About: WisdomTree Global (GNAT)

Roger Nusbaum submits: Long time reader Russell120 sent me a copy of John Mauldin's newsletter entitled CAPM is Crap, which is an attempt to turn the ideas of Alpha and Beta upside down.

Among other things was a chart that showed taking on higher beta does not result in higher returns. The article also has some positive things to say about fundamental indexing.

Quite frankly I felt as though I was reading things similar to what I have been writing about since I started this site (not claiming anyone stole my work, just a sort of like-mindedness). I think I can address some of the points made fairly concisely.

Higher beta does not result in better returns: Well there is one problem with this conclusion. A high-beta stock is likely to have its day in the sun, but eventually it will start to rain. Pick any internet stock from the bubble. Chances are it gave ten years', or more, worth of appreciation from 1998-1999. The person who sold his net stock on Dec 31, 1999 and never went back had a different experience than someone who held on to internet stocks too long. This is true for every stock market fad. Success with the next fad will not come from holding forever; it will come from holding for a couple of years, give or take.

When I write about beta I use the word volatility, not risk. Increasing risk is really not something people want to do. They may want to increase volatility to capture a general rise in the market, but there is never a good time to absorb an 80% hit to one of your stocks.

The primary objective of a portfolio is that there is enough money to meet whatever the goal is. Time horizon and how much you have will determine what the portfolio has to do to meet the goal. A 35 year old with $100,000 is probably off to a good start, but that person needs to save a lot and needs a normal exposure to the stock market. A 45 year old with $5 million does not need to save as much, nor does he need as much stock market exposure.

Let me define exposure here with an example. Take two $100,000 portfolios; one with a beta of 0.80 and one with a beta of 1.20. The latter has more exposure.

I have many posts up about low-octane portfolios. This is relevant here. People that save properly probably do not need to go for heroic returns. Getting market-equaling returns, or even returns that lag slightly with much less volatility, is an excellent outcome. I would consider anyone that can get away with taking this approach as being lucky.

It seems that fundamental indexing could be a path to this concept as perhaps an anti-alpha. I believe in it in moderation, but I think of it differently than most of the articles on the subject. I have disclosed many times owning WisdomTree Energy (DKA) for most clients. I did not buy it because I wanted a fundamental index. I wanted to sell British Pete (NYSE:BP) and needed to replace it.

Based on my view at the time (this was last November) I felt that single stock risk would not be rewarded, so that meant buying a sector fund. In the energy sector I favor more foreign exposure, so that meant I wanted a foreign sector fund. I looked under the hood and decided DKA would be my best bet. Fundamental or not was not a consideration.

Based on market history the likelihood of future corrections, bear markets and even a crash or two are very high. The emotional and financial benefit of reducing the impact of one or more of those future events would be colossal.

This topic can't be completely covered in this sort of a post, but you get the idea.