Modern Portfolio Theory says we have to accept more risk in order to get a greater return. Risk and return are tradeoffs.
We disagree.
Modern Portfolio Theory also defines risk as volatility.
We disagree with that too.
In August 2001, Yahoo Finance listed Enron’s beta as 0.77. Beta is a measure of volatility. A stock with a beta of one means the stock fluctuates in the same direction and in the same proportion as the market overall. A stock with a beta less than one means the stock fluctuates less than the market. A stock with a beta greater than one means the stock fluctuates more than the overall market. A stock with a negative beta means the stock is countercyclical: when the market goes up a stock with a negative beta tends to go down.
The intellectual elites have determined that high-beta stocks are riskier but have the potential for higher returns than low-beta stocks. That is, the greater the volatility in a company’s stock price, the greater the risk and the greater the potential reward for the stock.
That meant Enron in 2001 with a beta of 0.77 was less risky than the market overall. Enron at the time was the darling of the energy industry. Results were steady and moving in the right direction. The stock almost never declined.
The intellectual elites drool over beta like hound dogs over fresh meat. The irresistible allure of the metric is its ease of calculation using readily-available data. Any moron can calculate it. Lots of them do.
Beta, it is important to note, is calculated using historical price data. Someone looked at how the price of Enron stock bounced around historically, compared it with the market, and gave it a beta of 0.77. The intellectual elites then took that beta and, through the magic of defining risk as volatility, determined that Enron had somewhat less risk than the overall market.
In determining Enron’s beta, no one actually looked at the underlying company. No one assessed management. No one looked at the business. No one considered its market capitalization relative to its earnings power. The analysts calculating the beta didn’t even need to know what industry the company was in. An historical correlation of price movements led to a beta which led to the conclusion that the stock was less risky than the market.
The drool-worthy features of beta that appeal to so many academics are the very features that make the metric practically worthless to serious investors: it blindly extrapolates history into the indefinite future and doesn’t consider the underlying business nor the people who run it. What makes it appealing to the academics are the very things that make it worthless to investors.
Enron in 2001 traded for seventy times earnings, generated almost no free cash flow, and was run by crooks. This low-beta stock went on to lose about $70 billion of market capitalization over the course of twelve months. The stock literally went to zero.
Ironically, the moment the stock went to zero, the morons looking in the rearview mirror would have seen a spike in its volatility, raised its beta, and come to the conclusion that lo and behold the stock was riskier than the market. Thank you intellectual elite.
