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Be Careful When Investing In Low-Beta Stocks

Summary Beta is a common measure of a stock’s risk, and investing in low-beta stocks (low-risk stocks) has become a highly popular investment strategy among institutional investors today. Our new research shows that betas significantly change over time and seem to depend on the stocks’ ownership structure and how frequently the stocks trade. Low-beta stocks are often thinly traded; when investors buy into low-beta stocks, both their prices and betas increase. The opposite can occur when investors try to exit. Increases in institutional ownership breadth and the stocks’ turnover temporarily increase the stocks’ CAPM beta. The figure below shows the regression coefficients when future changes in stocks’ betas are regressed on changes in ownership breadth and turnover. Solid lines give the regression coefficients; dashed lines present 95% confidence intervals. Source: P. Jylhä, M. Suominen and T. Tomunen, “Beta Bubbles,” working paper 2015 Betting against beta All MBA and finance students learn in their basic finance courses the Capital Asset Pricing Model (CAPM), a theory largely attributable to the Nobel Prize winner William Sharpe. This theory states that riskier assets in equilibrium should earn higher returns, and that the relevant measure for a stock’s risk should be its “beta,” a measure of the stock’s systematic risk. Technically, a stock’s beta equals its correlation with the stock market index, scaled by the ratio of its volatility to the market index volatility. All well in theory, but in practice the CAPM has failed miserably. In real life, stocks with the higher risk measures, i.e., the high-beta stocks, have over the recent decades systematically earned lower returns than the low-beta stocks. In fact, investing in low-beta stocks has become a highly popular investment strategy in the financial market, one that is today aggressively marketed to all major institutional investors. Be careful: Betas do not measure what you think they measure In a recent working paper “Beta Bubbles,” written together with Petri Jylhä from Imperial College and Tuomas Tomunen from Columbia University, we suggest a potential reason why the logically well-motivated CAPM fails to work in practice. Most importantly, we show that the stock’s beta in reality seems to measure not only the stock’s level of risk, but also how frequently it is being traded. We study the US stock markets (NYSE and NASDAQ) starting from 1970s, and calculate the stocks’ betas annually from daily data using the Scholes-Williams (1977) method. We find that the low-beta stocks are commonly held by few passive long-term investors. These stocks have low average turnover; in fact on nearly 70% of the days, their trading volume is less than 0.1% of the stocks’ market capitalization. Intuitively, these stocks are so rarely traded that they rarely co-move with the market . This does not necessarily mean that the low-beta stocks are less risky, just that the traditional risk measure beta fails to measure their risk. The low-beta stocks are more prone to jumps, i.e. large market revaluations of their value. High-beta stocks, in turn, are owned by active, short-horizon investors that continuously trade and monitor the market. These short-horizon investors’ entry and exit from the stock market seems also to occur in tandem with the returns of the entire market. For both reasons, stocks owned by short-horizon investors co-move highly with the market. As the high-beta stocks are also more widely held, their risks are more evenly distributed amongst investors and the investors require less return from holding them. Hence the poor future returns to the high-beta stocks. Importantly, the stocks’ betas change over time as the stocks’ popularity changes. For instance, 20% of the stocks in the lowest-beta decile (the 10% of the stocks with the lowest beta) had an above median beta in the previous year. When a stock goes out of fashion and institutions sell the stock, we find that its beta declines. When a stock becomes popular among the active institutional investors, its beta rises. Low beta bets make sense – but prudence required The stocks in the lowest-beta decile are on average thinly owned and thinly traded. As many of them are unpopular among investors today, they, in principle, make up for great investments. However, as the low-beta investing has now become a popular investment theme, there is large risk that an investor investing in low-beta stocks today is in for a big surprise. The investor may find that the prices of low-beta stocks run up as he tries to take positions in these stocks. After all, these are commonly illiquid and thinly-traded stocks. Secondly, they may find that these stocks’ betas increase, as according to our working paper, the betas are a function of the investor population and the betas increase as the number of investors increase. Thirdly, the investors investing today in low-beta stocks should be expecting that these stocks’ prices drop vastly when all the investors following the low-beta investment theme today eventually try to get rid of their former low (now higher) beta stocks. So indeed, there is reason to be careful with your low-beta bets. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Price And Return Study On Class I Railroads

Summary In our ongoing efforts to point out the value of buying the least expensive stock, we have reviewed the price performance of the Class I railroads over fifteen years. We found that the most expensive stock outperforms about 50% of the time. The more relevant finding, though, is the powerful relative performance of the “cheap group” versus the “expensive group.” We offer this (non-scientific) study as the basis for discussion. We thought we’d take a break from talking about operating yields, the value of avoiding optimism and the fact that most expensive stocks disappoint over time to talk about the value of cheap investing as it relates to railroad investing. Although this short study was in the aid of our railroad obsession, we believe the findings are relevant to many sectors and stocks. We decided to review the price performance of the six Class I railroads for which we have data available for the period 2000-2014. We looked at which company was the least and most expensive on a PE basis at the beginning of each year from 2000 to 2014 inclusive. We then calculated the subsequent yearly returns for the cheapest and the most expensive railroads. The results are interesting (to us, anyway….we know…get a hobby). Results We found that “buying expensive” in some sense beat “buying cheap.” Specifically, buying the most expensive railroad at the beginning of the year was as likely as not to generate higher returns than the cheapest railroad over that year. Before concluding that there’s no value in buying cheap, though, consider that the mean return for cheap was much greater than buying expensive. Over the past fifteen years, on average, buying the cheapest railroad has produced a return of 23.56%, while the return for buying the most expensive railroad generated only an 18.25% return on average. We include the raw data at the end of this document. Source: Gurufocus Although buying expensive may beat buying cheap in any given year, over time, buying cheap has crushed the returns of the positive railroads. In our view, there was less risk associated with these cheaper stock returns also. We acknowledge that this is not a scientifically sound study. We will expand the study to include total returns from dividends. In future, we’ll review the tax consequences of this approach relative to a buy and hold approach. We will compare these returns to a benchmark (perhaps the transportation index). Before that, though, we believe that something need not be scientifically robust to be true. Although we’ll refine the work, this is sufficient evidence that buying cheaper railroads produces higher returns at lower risk than the alternative. Conclusion Although this short study looked only at the Class I railroads, we believe there’s a wider lesson here. Although expensively priced stocks may outperform in a given year, they will perform less well over time. Given that they’re coming from a much less expensive base, cheaper stocks almost inevitably outperform over time. (click to enlarge) Source: Gurufocus Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Built For Action

We humans are doers. We want to move, to make, to accomplish, to act. We do not take kindly to sitting idly by. We do not enjoy being bored and most of us struggle to sit quietly alone. It is increasingly easy to distract ourselves, to push away the quiet. Unless I’m asleep I am within arm’s reach of my phone about 95% of the day. Why sit quietly when Twitter and Instagram await?! Last year I read 10% Happier: How I Tamed the Voice in my Head by Dan Harris (at the recommendation of this post by Shane Parrish at Farnam Street). It is a great reflection on the difficulty of our busy lives and our ability to focus and slow down. Harris, after having a panic attack on national television, explores a path towards meditation and trying to relieve his anxiety. In doing so, he finds that meditation is hard. It’s really hard. Sitting and trying to focus on a single thing (typically breathing) without being distracted by thoughts of work, family, hobbies, to-do lists, dentist appointments and everything else. We are just not very good at doing nothing. This is especially true as investors. And we really don’t like it when are portfolios do nothing. We’re sitting in the doldrums right now. Returns everywhere are nowhere. Here’s a quick rundown of 12-month returns through 9-15-15: S&P 500: 1.77% Russell 2000: 3.05% Barclays Aggregate Bond: 2.32% MSCI EAFE: -6.34% MSCI Emerging Markets: -23.58% US Real Estate: 1.89% Other than Emerging Markets being pretty painful, those are some pretty unexciting numbers. A weighted average of those for a balanced investor is probably going to put you in the -3%ish range for twelve months. A little painful, but probably not panic-inducing for most. And yet, it itches. You get your statement and look at the numbers and it just tickles your nerves a little bit. “Should I do something?” it asks. “What’s not working?” it wants to know. “Have I made a mistake?” “What should I do?” “How do I fix it?” They are quiet questions, but there they are, lingering in the back of our minds. We only get one chance at this investing thing, and we’re terrified that we’ll get it wrong. We’ll miss out on opportunities or hire the wrong advisor or buy at the wrong time or have to listen to our brother-in-law at Thanksgiving talk about how he nailed it AGAIN this year. Hopefully, we have the other voice too. The calm, rational one that reminds us that we have a plan. A pretty well-thought-out plan. A plan that involves boring years and periods where returns don’t meet our expectations. This voice should remind us that we knew about that going in. It doesn’t necessarily make it easier to remember that, but it ought to handcuff us. Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.