In my career as a teacher, I have often come across the thought that the biggest problem with the concept of education is our ability to define the word (education) properly. When we teach our children, the typical middle-class Indian often confuses information with education. To me, education is all about building attitudes… the most beautiful thing about this is that it does not need a classroom.
Attacks on Classical Finance
For example, one of my first actions at the start of a course is to launch an attack on the concepts of Classical Finance. I find that Classical Finance is full of good-looking, logical (this word is often mistakenly confused with rational), and mathematical models that assume away reality. This obsession with logicality, in order to be ‘rational’ is probably the real reason why Classical Finance is often irrelevant in the pursuit of investing success.
In CAPM, for example, Harry Markowitz set out to build the perfect portfolio. Very simply, he equated the volatility of a stock with the risk embedded in it.
CAPM allows investors to calculate the weights to give to each stock (given expected return, expected risk, and the correlation) in order to achieve the portfolio with the greatest return for a given level of risk. Investors can have mean-variance efficient portfolios, i.e., they will minimize the variance of portfolio return, given expected return, and maximize expected return given the variance.
CAPM rests on the concept of beta, the single factor that distinguishes between any two stocks in a portfolio universe. Everything else was assumed away. Beta, therefore, emerged as a surrogate measurement for Risk.
Understanding of Risk
Meanwhile, I have a different understanding of Risk. With my firm belief in the underlying irrationality of man, I define Risk as the level of ‘foolishness’ in the stock. Foolishness, or ‘feta’ as I call it, is a measure of the amount of human misperception embedded in the behavior of a stock. According to me, ‘Feta’ would be a better predictor of portfolio returns than the better-known Beta. I pointed to some Feta in a previous article about Tata – Corus.
No doubt, Feta is much more difficult to measure with a nice, round number, which can be multiplied with the “Risk-free Rate” to give you the Cost of Capital, the benchmark return against which all money managers must measure themselves. But that is precisely the point of this article… if you set the bar at a convenient but wrong height, you will never even start to figure out how well you did.
I have a detailed article on the philosophical understanding of Risk and Reward, do check it out, it’s worth a read.
The Beta Enthusiasm
But enough of my own (irrationalist) version of CAPM. In the ‘real’ world of Classical Finance, many studies have found that Beta is NOT a good indicator of Risk. Portfolios constructed with the Markowitz model tend to underestimate the potential returns to low-beta stocks, at the same time massively overestimating returns from high-beta stocks. Over the long run, there has been the little relationship between the Beta of a stock and its long-term returns.
I have my own explanation for this. Beta, in some way, measures the relative enthusiasm in a stock (relative to an Index, or market, for example). Beta, therefore, is sometimes a measure of the linear underlying sentiment in a market, exuberant enthusiasm in a raging bull market, or demented depression in a dying, bear market. Under such conditions, high Beta stocks will actually turn the most bearish in a downturn (like Real Estate stocks in the recent Feb ’07 sell-off), while low Beta stocks will therefore outperform their erstwhile leaders, like Hero Honda, a laggard in the last 2 quarters, did not drop with the market during the recent crash.
Playing Beta Well
Under certain conditions, Beta is the manic-depressive face of Warren Buffet’s “Mr. Market”, the fool who sells you his shares on the cheap, only to buy them from you at crazily inflated prices shortly thereafter. During such periods, it might make sense to weight your portfolio towards low-beta stocks. In 2001, I was short on IT stocks and bought sugar stocks. The former tanked 65% on average, while the latter went up 30 times in 4 years. I am looking for low Beta stocks again just now, as I expect another bear market. High Beta? Take a look at Real Estate!
In the US, studies over the 60s show that over a large universe of 600 stocks, stocks with the lowest Beta have given the highest return, while those with the highest Beta have given the lowest return. This is the complete inverse of the CAPM predictions. What is true of stocks has also been found to be true of portfolios, i.e., low Beta portfolios generate higher returns with lower risk than the mainline market indices.
Interested In Understanding the Details
For those who are interested in understanding this in detail, a recent portfolio constructed out of Reliance Energy, Tata Steel, and Hero Honda has obtained a Beta to the Nifty of 0.3. The ROI is running at above 400%, ignoring taxes. If one assumes that the downside risk on the Nifty is 30-40%, and this track record is maintained, we have a Risk: Return ratio of 1:10. That is a fairly safe strategy in the worst of circumstances.
Ben Graham once argued that “Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability, yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management”.
CAPM assumes:
- No transaction costs (no commission, no bid-ask spread)
- Investors can take any position (long or short) in any stock of any size without affecting the market price
- No taxes (so investors are indifferent between dividends and capital gains)
- Investors are risk averse
- Investors share a common time horizon
- Investors view stocks only in mean-variance space (so they all use Markowitz’s optimization model)
- Investors control risk through diversification
- All assets, including human capital, can be bought and sold freely in the market
- Investors can lend and borrow at the risk-free rate
Let us take a few of the above assumptions, to see how artificial they are. Any portfolio allocation that is based on relative volatility would have to be dynamic, with a large number of portfolio shifts. How can there be no transaction costs, or how can transaction costs be minimal?
Institutional Investor
Any institutional investor will tell you that it is impossible to enter or exit the market without disturbing the price discovery mechanism. Only individual investors can do that, and they don’t use CAPM. In any case, individual investors cannot lend or borrow at a risk-free rate.
In a previous article on Tata Corus, I showed you how different investors have different time horizons. The market has many blind spots, some of them constant and unchanging.
Ask any Mutual Fund manager whether he thinks of upside variability as Risk. More likely, he will lump it with the return. The entire Mutual Fund industry sells ‘outperformance’, i.e., the measure by which a Fund has ‘outperformed’ the Sensex. They think of Sensex performance as their ‘cost of capital’. The Beta of stocks or portfolios is perhaps too complex for the simple Indian investor.
Should these Funds now be promising an expected loss of 20%, outperforming a Sensex that might lose 30%? If individual investors like me can construct ‘absolute return’ portfolios that produce a validated return over the long term, why can a sophisticated Institution not develop a similar strategy? I think this makes out a case for allowing Indian Hedge Funds in some form or the other, but that should be discussed some other time.
