Beware the Imitators

The other day while driving in to work I was listening to the local sports station. Every morning, as part of their advertising, they have a local business come on for a scripted interview with the business owner or sales manager– essentially a 3 minute commercial.  On this station it is usually the local Toyota dealership, or a particular local financial advisor.

 

I do take some interest in what our competition is talking about, so I paid particular attention when I knew it was going to be the financial advisor. Much to my surprise the advisor started to talk about “beta”.  Beta is a term from the world of finance, and actually is used in a very influential and basic model that is meant to explain the movement of securities prices and expected return.  I was surprised to hear the advisor talk about something scientific in nature.  But I was equally surprised to hear what came after.

 

While it was nice to hear an advisor talk about something based in science, the problem was he was just plain WRONG in his explanation- or at least very incomplete. He said that BETA was a measurement of how volatile a portfolio, fund or stock was.  So, the market he said, has a beta of 1 (that is right).  If you had a beta of more than one, your portfolio was “more volatile” than the market.  And if the portfolio had a beta of less than one, it implied it had less volatility.

 

Unfortunately this is the wrong definition. Beta is a measurement of correlation and risk as it relates to the market. It explains the movement of a portfolio in relation to the market, and is used to calculate an expected return.  If a portfolio has a beta of 1, it just means it is the market’s mirror image (moving in lockstep with it), and does, by default, have a volatility equal to the market’s.  But let’s say a portfolio has a beta of zero?  Does that mean no volatility?  Not at all.  It just means that there is no discernable correlation or link between the return of the portfolio and the return of the market.  Or in other words, it means that the return of the market will not affect the return of your particular portfolio- they move independently.  His definition is especially wrong when you look at negative betas.  Does a beta of negative one mean that there is “negative” volatility or no volatility?  No.  That simply means that the portfolio tends to behave the exact opposite direction of the market.  Its volatility could be exactly the same.  Standard Deviation would have been a better fitting concept if you want to measure volatility.  A portfolio with a 0 beta or negative beta could still be very volatile.

 

Advisors will use any number of smart sounding terms to try to prove their knowledge or savvy. It is hard for individuals to decipher what is accurate and what is not.  (My wife even said, really Jeremy? Who would be able to tell that he was wrong??).  That is an unfortunate problem.  But this is a good example of the importance of your own due diligence.  Just because an advisor uses fancy words doesn’t mean they are using it correctly.  Do your own homework to see if there is actual substance and knowledge behind the words used.