Get a Better Beta for Survivorship Bias

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From Nick Hubble in Scoops Lane:

Everything except the weather is hotting up in Europe. Finance ministers are meeting to ‘discuss’ the debt crisis. At least they won’t make it worse. But the German Chancellor’s visit to Athens might.

Her security force is probably about the same size as the army the Germans invaded Greece with last time around.

In America, it’s earnings season. That could be downright icy, with a recent poll indicating 62% of American consumers believe the US is already in recession. Apart from the stock market, the unemployment rate and GDP, major indicators are worse than they were during the 2008 recession.

Living standards haven’t increased from 1997 levels, and median income is back to 1989 levels. Ominously, it fell faster during the recovery than the recession!

It may be time for Australian investors to batten down the hatches. There are plenty of ways of doing it though.

Beta‘ and ‘Survivorship Bias‘ are two of the stock market’s dirty secrets. But in the world of finance, two dirty secrets make an opportunity.

Today’s Daily Reckoning is about how you can use something called Beta to avoid being fooled by something called Survivorship Bias during tough times for the stock market.

Survivorship Bias occurs because only successful companies stay in the widely quoted stock market index. If a company’s share price performs terribly, it will eventually drop out of the All Ordinaries Index, or the S&P500. Meanwhile, a growing and successful company will take its place.

The result is a steady upwards bias on the index over time, while real investors are left holding the occasional lemon (a ‘lemon’ is a metaphor for something sour which you expected to be sweet).

Our bet is that a clearing out of companies like Lehman Brothers and Bear Stearns from the American indices substantially overstates the stock market’s performance over the last 5 years. The more turmoil, the more the bias influences the result.

That’s one reason the American market looks to be doing better than it really is for real shareholders.

Beta is a little bit more difficult to understand. The best way to go is with an example. That’s because the other option looks like this:

Beta:
Variance:
Covariance:

 

In the stock market, Beta measure’s the change in price of individual stocks relative to an index. The index represents the wider market. Here’s a quick example that will make the whole thing click for you.

If the stock market index moves up 1%;

  • a stock with a Beta of 1 will go up 1%
  • a stock with a Beta of 2 will go up 2%
  • a stock with a Beta of -1 will go down 1%
  • a stock with a Beta of 0.5 will go up 0.5%

Not difficult right? A couple of things to remember. This is based on a ‘typical day’. It won’t be accurate each day, but usually is over time. Secondly, a Beta can change based on the time period you calculate it on.

Banks tend to have high Betas during financial crises, for example. And lastly, Beta only tells you information relative to the broader market. It doesn’t tell you anything about the actual returns you can expect.

It won’t tell you if the stock will outperform or underperform the market, just how it will perform relative to how well the market performs.

So now you know how Beta works. But how do you use it together with Survivorship Bias? Well, risky stocks have high Betas. They are volatile. And, because of their risky nature, they are more likely to fail too. So if you own high Beta risky stocks, you increase your risk of underperforming the market index because of Survivorship Bias. One lemon can sour a whole portfolio.

The antidote is to construct a portfolio of shares with low Betas.

That’s a very different statement to saying the portfolio has a low Beta as a whole. This is what your broker probably focuses on — the Beta of your portfolio, not of the individual stocks in the portfolio.

Just as shares have a Beta, which tells you how they perform relative to the market, so does a portfolio. It’s just the average Beta of the shares in it. And that’s the big problem. A basket of oranges and lemons doesn’t taste ‘average’.

It tastes either sweet or sour depending on which one you bite into. What you want is a bunch of oranges without any hidden lemons.

Most people try and have a low Beta portfolio by picking some safe stocks and some risky ones. The average Beta hides the fact that some of the stocks are risky. And if just one of the risky stocks gets into trouble, that can compromise the return of the whole portfolio.

So, rather than picking stocks with a range of Betas and feeling safe because of their low average Beta, it may be better to pick a bunch of stocks with the low Beta you want to have in the first place.

All this doesn’t mean you can’t speculate on risky opportunities with some ‘play money’. It just has to be money you can afford to lose. Even the crisis proof Denning Report’s portfolio has some ‘ultra-speculative punts’.

But Dan’s methodology is a little bit more savvy than stock picking. He likes to find entire industries or areas of the economy that will do well, and then pick a range of stocks in that area. Academic studies have supposedly shown that stock picking is a doomed endeavour. Is it better for entire sectors of the market?

Anyway, if you want to find out more about Beta, you can look up individual shares’ Beta on your broker’s website. The symbol looks like this, ‘ß’ It’s usually one of the characteristics displayed in the summary of a stock.

And you can probably find a way to calculate your portfolio’s Beta with your broker too. Just remember that averages can be misleading and Beta’s can change.

You might not want to go about changing your entire portfolio based on Beta. But, from now on, if you buy a share, make the point of informing yourself of its Beta and how that Beta will affect your portfolio.

It will make the share’s price movements and the changes in the value of your portfolio less of a surprise.

Regards,

Nick Hubble
for The Daily Reckoning Australia

From the Archives…

Derivatives as a Sponge
5-10-2012 – Greg Canavan

Don’t Teach Your Man to Fish
4-10-2012 – Nick Hubble

Three Phone Calls You Must Make Now
3-10-2012 – Nick Hubble

Beer and Tax in Retirement
2-10-2012 – Nick Hubble

Hard Times for Hard Rocks
1-10-2012 – Dan Denning

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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There are two problems with this analogy. A low beta under performs a rising market and may not lose as much in a bear market. You lose both ways with low beta. Additionally beta is based on market prices and indices and not intrinsic value. Again you lose because 95% of the market does not pick stocks of higher intrinsic value than market price. Rather they go with the flow that is 95% in the negative. A further reason for financial crisis. The capital asset pricing model is also flawed when you have high levels of debt and derivatives causing… Read more »
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