As a kid, I was scared to death of roller coasters. I never went on them. But in the summer of 1977, peer pressure changed that. The last day of summer camp featured a trip to Six Flags Over Georgia. After riding just about every ride in the park, my cabin -- the Badger Den -- had one left to conquer: the HUGE wooden roller coaster named "The Scream Machine." Every member of the Badger Den was wound up and ready to ride.
Well... just about every member.
I had a dilemma: I was terrified. I was also an 11-year-old in a pack of 11-year-olds. Did I say, "That's OK guys, I'll just wait right here till you get back?" Of course not. That would have been an invitation for humiliation. The kid who wet his bunk was raring to go. How could I not? I gulped. I made a fist. I bowed up. I rode "The Scream Machine". And it was a blast.
Today, I wouldn't say I love roller coasters, but I'll ride them with no fear. I'm partial to the ones that don't do loops, though. I've ridden them, but I can tolerate the ones without loops better than the ones with loops.
A roller coaster is probably the most common analogy used with the stock market. And, like an amusement park, investors can choose which roller coaster they prefer. It's all about a little thing called beta.
What does beta
According to InvestingAnswers.com, beta (or the beta coefficient) is "a measure of a stock's volatility relative to the overall market. It is most often calculated using a stock's movements relative to the S&P 500 Index over the trailing 12-month period.."
Think of beta as the tendency of how an investment's return responds to swings in the market. For example, if a stock has a beta of 1, then this implies its price will move with the market. If the beta is less than 1, then the stock will probably be less volatile than the market. A beta greater than 1 indicates the price is likely to be more volatile than the market. Therefore, if a stock's beta is 1.2, then, it would theoretically be 20% more volatile than the market.
Simply put, higher beta means higher risk and lower beta equals lower risk. And in equity investing, typically higher risk can yield higher reward. Right? Well, this may not always be the case. Here's why...
Using some fancy, Morningstar modeling software, I created two baskets of stocks, a high-beta and a low-beta basket, then I ran a 10-year back test. The results were surprising.
A tale of two baskets
Let's create two investors: Fast Freddie and Slowpoke Pete. In 2001, Freddie was still convinced the bull market in growth stocks still had legs. So, Fred allocated $50,000 equally among five stocks: Amgen (Nasdaq: AMGN), Bank of America (NYSE: BAC), Cisco Systems (Nasdaq: CSCO), Starbucks (Nasdaq: SBUX) and Yahoo (Nasdaq: YHOO).
Pete took a different approach. Stocks always made him a little bit nervous, so he would gravitate toward older, stodgier names that paid a dividend. His thinking was that the returns might not set the woods on fire, but he'd get paid something just for showing up. Pete took his $50,000 and spread it evenly among Abbott Labs (NYSE: ABT), Automatic Data Processing (NYSE: ADP), Kimberly Clark (NYSE: KMB), PepsiCo (NYSE: PEP), and Procter and Gamble (NYSE: PG).
How did each basket perform?
The high-beta roller coaster
If Freddie's basket of stocks were a roller coaster, then it would be called "The Whiplash." The portfolio's 10-year beta came in at 1.04, which, considering the benchmark's (S&P 500) beta was 1.00, it doesn't sound all that volatile.
But the numbers tell a different story.
While Freddie's $50,000 grew to $69,533, the average annual total return came in at 3.68%. This includes a blended dividend yield of 1.14%. Freddie's high-beta basket also turned in negative numbers 40% of the time. To top this off, they were two, back-to-back two-year periods: -29.8% in 2001 and -8.6% in 2002; and -27.7% in 2007 and -38% in 2008.
There was an upside, too..Both consecutive two-year down periods were followed by big back-to-back sky-rocketing years: 2003 came in at 79.2% and 2004 was 48.7%, while 2009 and 2010 rocked with 57.3% and 18.4% respectively. Still, that's a lot of up and down for a return that barely beat inflation.
So let's take a look at how Pete's basket did...
The low-beta roller coaster
With a 10-year beta of just 0.47 (54.8% less volatile than Freddie's basket), Pete's $50,000 outgrew Freddie's by 11% to $77,702, bringing the average annual return to 4.15%. This was not a huge gap as compared with the growth basket -- just 47 basis points -- but it's an outperformance nonetheless.
Even more remarkable was that Pete's low-beta portfolio had only two down years in a decade, giving up just 16.1% during the post 9/11 bear market of 2002 and only down 15% during the mauling of 2008.
And what about yields? The low-beta basket paid Pete 215 basis points more, with a blended dividend yield of 3.3%. Granted, soap and toilet paper weren't nearly as sexy as the Internet or frappachinos, but they sure held their ground in a grinding, decade-long secular bear market.
Risks to Consider: Whenever discussing portfolio performance based on backtesting and illustrations, you are always looking in the rearview mirror. Lower volatility doesn't necessarily mean lower risk. Security values can and will go down.
Action to Take--> Evaluating the beta of a stock portfolio is just one aspect of investment selection, however, it is an effective tool in assessing and managing investment risk. This type of data is readily available on most investment websites. Yes, many arguments can be made for and against low-beta investing. But the overriding theme here is that investors can often achieve better results by sticking with boring "forever stocks" (that's what StreetAuthority Co-founder Paul Tracy calls them) -- stocks you can own and sleep well at night, confident you'll earn a good return with little risk. Judging by the numbers, the case for low-beta stock selection is strong, based on performance during a terrible decade for equity investing. Combined with a fundamentally good stock selection, it's an effective way to manage volatility and preserve capital.