Saturday, July 09, 2005


Having reported a number of times that a family member owns a high beta portfolio, I receive questions about Beta. Fridays action supplies a good example to explain the concept.

Friday produced the following results:

Dow up 1.42%
S&P up 1.17%
NAS up 1.79%
IBB up 2.64%
FAM up 2.73%

The Dow contains very big slow growth stocks and is not very volatile. However, it is an index of only 30 stocks. The Dow went up by more than the S&P on Friday but over long periods of time the S&P is more volatile on average than the Dow and its long term performance is likely to be better.

The NASDAQ index contains high tech stocks which are more volatile on average than the average S&P or the Dow. Whereas the IBB, a fund of bio-tech stocks, is on a roll. It is moving up quickly.

FAM is the aggressive family account. It does not include any bio-tech stocks (I simply have no feel for them and tend to avoid what I don't understand.). Never-the-less, it does include high tech stocks and out of favor stocks which include 5 airline stocks.

This account has done extremely well. It has hit net new highs several times in recent weeks and closed again Friday at another net new high. I use the term net new high because I net out any additional funds that have been deposited since the last new highs were made. The big winners in this account this year have included AMTD, GOOG, ET, GLW, and 4 out of 5 airline positions.

This account has out-performed the market dramatically from the date it was opened until now. Alpha is the term used for out-performance. When you read the words, "seeking alpha" you should interpret that the writer is trying to beat the market. Always keep in mind that the majority of all investors, including the majority of professionals, under-perform the market. Also keep in mind that beating the market is not necessary to become very wealthy.

It is in trying to beat the market that risk is added. One can invest in an index fund and capture about 98.5% of the market return. One can dampen the volatility with a balanced account and still capture about 90% of the market return. Or one can invest in a high beta or volatile mixture of stocks in an attempt to beat the market.

Here again, one can take the easy approach or one can "play the game". For example, one can invest 100% in small cap stocks and beat the market over long periods of time. Using this approach, one will suffer huge draw downs during the tough years but those who hang tough will enjoy even larger gains in the good years.

My choice is to "play the game". I buy what is hard to buy. Sometimes that is a Google at 70 times earnings, sometimes it is volatile resort rental property during a real estate recession and sometimes it is an airline at .05 times sales! Life is meant to be fun. If one can be aggressive and sleep well, then the joy of hitting home runs will more than compensate for the strike outs along the way.

Low beta high yield stocks are not bad substitutes for bonds that are priced at historic highs. High beta stocks are for those who want some action. Diversification is important to avoid taking a big hit when your guesses are bad.

Right now, the odds favor aggression. The last time the earnings yield on stocks was higher than the yield on bonds was the summer of 1982! Aggressive investors did very well for the next 10 months--until bond yields zoomed up while stock yields zoomed down.

If memory serves, it was Michael O'Higgins who wrote a couple of books titled something like Beating the Dow with Bonds. His premise was simple. If the S&P earnings yield is higher than the yield on 30 year bonds, one should buy stocks. If the bond yields are higher, he suggest that you buy long bonds if Gold has gone down year over year and stay short if Gold has gone up year over year.

Since the S&P earnings yield is about 1.5 times the 4% yield on bonds, we buy stocks and not worry about bonds. However, worry warts will correctly point out that PE ratios are inversely related to the yield on bonds and therefore, if bond yields go up, stock PE ratios should go down. There are several rebuttal points. Earnings are growing. There is a huge cushion since stocks are making so much and the price of Gold is down for the past year! Gold is indicating that inflation is not a problem. The price of Gold suggest that bond buyers should go long!

I can't do it! I cannot buy long bonds at 4.3%. With conservative money, I would rather buy AAA high yield stocks. If stocks are not an option, I'd rather take the short term hit and stay with the highest yielding money market account available. If forced to buy bonds, I would buy an intermediate fund. Of course, I manage my 82 year old mothers account and a few retirement accounts very differently than the way I manage my families aggressive account.

The bottom line is that I seek alpha and understand that I must accept beta. I seek to beat the market and accept volatility as the price for having a whole lot of fun. One must experience pain to know real joy. I have had my share of both; Praise the Lord!