Ang's Book Helped Me Understand Beta Better

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Random Walker
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Ang's Book Helped Me Understand Beta Better

Post by Random Walker » Fri May 08, 2015 8:29 pm

Trying to read Ang's Asset Management. In describing CAPM, he defines beta very nicely. Previously I had just thought of it as volatility. But apparently it's defined as

(Volatility of asset)(correlation to market) / volatility market.

He calls beta a measure of the Lack of Diversification Potential of an asset to a market portfolio.
So the way I read it, one can achieve low beta with either low volatility or low correlation to the market, and an asset class with low beta should be a very powerful contributor to portfolio efficiency. Interested to hear other thoughts.

Dave

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JoMoney
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Re: Ang's Book Helped Me Understand Beta Better

Post by JoMoney » Fri May 08, 2015 9:50 pm

Random Walker wrote:...So the way I read it, one can achieve low beta with either low volatility or low correlation to the market, and an asset class with low beta should be a very powerful contributor to portfolio efficiency. Interested to hear other thoughts.

Dave
Probably not the discussion you're looking for, but... While I find the CAPM and "beta" topics interesting, I take it with a grain of salt. The idea that this explains a stocks return relative to the market sometimes works, and sometimes doesn't. The fact that it doesn't work under some circumstances or time frames pretty much proves that it's either not true or that at least it's not the whole story...
http://en.wikipedia.org/wiki/Capital_as ... ms_of_CAPM

Fama and French came out with a "Three Factor Model"
http://en.wikipedia.org/wiki/Fama%E2%80 ... ctor_model
Where they believe that additional aspects like a stocks relative market-cap size and book value explain the risk and relative returns.

Over time, even more "factors" seem to be found and various new models or adjustments for trying to measure a stocks risk and return relative to the market have come out. Some financial companies have created mutual funds around these factors dubbing it "smart beta" and market them to investors that want to play with their portfolios risk/return profile (at least as it's measured by these new betas).

I expect that these new factors will be found lacking as well, I don't think any of the strategies these funds are based on are even new. It's just the same old active management styles stock funds have tried for decades, but with a new story behind it. They sell them to investors eager to enhance their returns under an "Efficient Market" paradigm (that Ph.D. academics barely understand, and want to sell it to common folks that understand it even less).

To some extent, I think part of the problem is with the initial premise in believing that the market is efficiently pricing "risk premiums" in the first place. These various models seem to start with that premise, and then try to come up of ways to measure the "risk", and when the models are found lacking they keep looking for a new model rather than accept that the initial premise is false.

Me, quoting Mr. Bogle, quoting Nobel Laureate William Sharpe:
"Smart beta makes me sick!"

As far as I'm concerned, the same goes for trying to develop strategies around the CAPM style of beta.
Warren Buffett wrote:...Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing
formulas.
http://www.berkshirehathaway.com/letters/2008ltr.pdf
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Ang's Book Helped Me Understand Beta Better

Post by lack_ey » Fri May 08, 2015 10:25 pm

I think it is well understood that market beta does not completely describe individual security (or fund) returns.

Regardless of whether or not the model is entirely accurate or even worth building off of, to me this notion of beta passes some kind of test of usefulness. When you resort to these kinds of (primitive?) analyses and crunch out correlation and beta results, you now have some kind of statistical characterization of past behavior. And empirically, it is seen that the persistence of these numbers is high enough for these to be useful as some kind of gauges of future behavior (higher than return persistence at least, though that's not saying much). Low-beta stocks tend more often than not to have low beta in the future, for example. Bonds and commodities, among others, tend to have very low stock market beta, as you might expect.

Just looking at CAPM beta, the iShares junk bond ETF (HYG) comes in at 0.60 since 2007 (a different regression using other factors such as term risk would produce a different result). This says something about the ability to diversify stock risk and that you might expect some damage when stocks tank. A portfolio of 30% stocks and 70% cash would have a beta of 0.30 and a correlation of 1 with the stock market. Some kind of black box multialternatives fund might have a beta of 0.30 (to stocks) but a significantly lower correlation to the stock market, which would imply some net influence of stocks but perhaps some other sources of underperformance or overperformance from other net asset exposure. Another fund with a beta of 0.30 and high correlation to stocks and suspiciously similar performance to 30% stocks and 70% cash (gross of fees) would seem pretty pointless. And I'm not sure you can really eyeball these things on a returns graph, so the metric really is saying something.

Yes, there's the possibility the characteristics change in the future or who knows what else, but that's the uncertainty we live with. To me it's just another measure, a tool to have opposite the salt shaker. Not necessarily the best one, but something to consider. You use it and see if it jives with what else you know, and if a result is surprising, you try to find out why that might be.

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Random Walker
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Re: Ang's Book Helped Me Understand Beta Better

Post by Random Walker » Fri May 08, 2015 10:58 pm

I've become a bit of an asset class junkie. I'm a huge fan of Roger Gibson's Asset Allocation and multi asset class investing. I really appreciate the fact that an asset class' contribution to a portfolio depends on expected return, volatility, and correlations. Never learned much about CAPM, but really appreciate how this description of beta as a measure of "lack of diversification potential" fits into modern portfolio theory as we use it in practice.

Dave

Here is a link to a short paper by Gibson with a few excellent charts that effectively summarizes the main point of his book:

http://www.amcham-shanghai.org/amchampo ... esting.pdf

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Re: Ang's Book Helped Me Understand Beta Better

Post by DaufuskieNate » Sat May 09, 2015 9:58 am

JoMoney wrote:While I find the CAPM and "beta" topics interesting, I take it with a grain of salt. The idea that this explains a stocks return relative to the market sometimes works, and sometimes doesn't. The fact that it doesn't work under some circumstances or time frames pretty much proves that it's either not true or that at least it's not the whole story...

To some extent, I think part of the problem is with the initial premise in believing that the market is efficiently pricing "risk premiums" in the first place. These various models seem to start with that premise, and then try to come up of ways to measure the "risk", and when the models are found lacking they keep looking for a new model rather than accept that the initial premise is false.

Me, quoting Mr. Bogle, quoting Nobel Laureate William Sharpe:
"Smart beta makes me sick!"

As far as I'm concerned, the same goes for trying to develop strategies around the CAPM style of beta.
I think that when we throw out CAPM in its entirety, we also throw out a lot of the foundational premise for basic Boglehead philosophy. Sure, its an imprecise and imperfect model. But CAPM establishes the premise that risk and return are linked over some meaningful time horizon. When we say that it doesn't always "work" what does that really mean? If over some timeframe a risky asset does not perform as expected, does it mean that CAPM is not true or is this simply a reflection of the very risk that the market attempted to price in the first place? If there is "risk" in an asset then by definition there is the possibility that the price assigned to that asset today may in hindsight be incorrect. This does not necessarily throw out the entire notion that the market efficiently, or even inefficiently, assigns a price today that reflects that risk.

If we throw out CAPM completely, then what basis do we have for ANY particular asset allocation? None.

If we throw out CAPM entirely, is there any reason to "stay the course?" No.

If assets are not priced on the basis of risk, or if that risk is completely unknowable, then we are no longer investing. We are simply engaged in a game of random chance. Now, perhaps some believe that to be the case, and that's fine. Just realize that in that notion you are now free to follow anything your reason or emotion dictates because Boglehead principles don't really apply any longer.

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Yesterdaysnews
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Re: Ang's Book Helped Me Understand Beta Better

Post by Yesterdaysnews » Sat May 09, 2015 11:34 am

Economics is not a science and there should be no Noble prize in it, especially since there is not one in Math.

While EMH and CAPM etc are all nice economic models there are many anomalies and other inefficiencies in real life.

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Archie Sinclair
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Re: Ang's Book Helped Me Understand Beta Better

Post by Archie Sinclair » Sat May 09, 2015 11:43 pm

Yesterdaysnews wrote:Economics is not a science and there should be no Noble prize in it, especially since there is not one in Math.

While EMH and CAPM etc are all nice economic models there are many anomalies and other inefficiencies in real life.
Some would say that there is no Nobel Prize in Economics. The Economics prize was created by the Swedish central bank in 1969, not by Alfred Nobel in 1895 like the other prizes. Some members of Alfred Nobel's family disapprove of the use of his name in connection with the Economics prize.

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JoMoney
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Re: Ang's Book Helped Me Understand Beta Better

Post by JoMoney » Sun May 10, 2015 12:50 am

DaufuskieNate - I don't think EMH, or CAPM, or any of the related models are central to the core of "Boglehead principles". At least not if they're based on what John Bogle has wrote over the years.
The proof that stock investors as a group can't outperform the market in aggregate stands regardless of market efficiency. The fact that expenses incurred will subtract from that remains... And then there's all the empirical evidence, that despite decades of trying, mutual funds have underperformed the benchmarks.
I posted this in another thread, but will use it here as a response as well:

If markets are efficient, then the only major difference between one portfolio and another is fees and risk/return preferences. A "slice-n-dicer" may earn more over time, but any excess return was only for assuming more risk - which should be measurable by some model even if the academics haven't quite come up with one that explains all of the real markets risk/return in an efficient way (yet).

If markets are not efficient, things get tricky, it means there is asymmetric information in the market. People who know more about an asset have an incentive to trade their "risky" assets (risk being the likelihood of losing money - or not earning as much) on to people who don't have that information. The more information that gets out, and the more participants in the market, the more "efficient" like it should become as people trade on what is known. So if you're buying with the expectation that you're going to earn an above market average return, you have to be doing so under the belief that you know something the seller (or the average market participant) doesn't, or you could be taken advantage of. In an in-efficient market, it could be even more dangerous to reach beyond what the average consensus "prudent man" view is, which should roughly correlate with what is reflected in a cap-weighted broad-market index.
The Inefficient Market Argument for Passive Investing
...In other words, market efficiency protects the less-skilled investor from consistently making bad investments because all stocks are fairly priced. There is, on the other hand, no such protection in a market where stocks are routinely mispriced. The active investing majority that underperforms the index will tend to be the same year after year. Thus, the argument for indexing is even stronger for individual investors if the stock market is not efficient. The game of poker provides, in some respects, an instructive analogy. Poker is a zero sum game, similar to active investing compared to indexing, and poker combines luck and skill, consistent with the assumption of a less than perfectly efficient market. An old adage among professional poker players applies to those deciding to participate in the active investing game. "If you don't know who the mark is, get up and leave the table, because it's you."
John Bogle wrote: http://johncbogle.com/speeches/JCB_Morningstar_6-02.pdf
... In a temporal sense, the all-market portfolio is consistent with the spiritual argument about the existence of God put forth by Pascal three centuries ago. If you bet God is, you live a moral life at puny cost of giving up a few temptations. But that’s all you lose. If you bet God is not and give in to all your temptations, you’re forever dammed. Consequences, Pascal concluded, must outweigh possibilities. Similarly in the stock market, if you bet the market is efficient and hold the market portfolio, you’ll earn the market’s return. But if you bet against it [the market portfolio] and are wrong, the consequences could be painful. Why would you run the risk of losing, perhaps badly, when the market return, earned by so few over the long-run, is there for the taking?
John Bogle wrote: http://johncbogle.com/speeches/JCB_Brinson0404.pdf
...we don’t need to accept the EMH to be index believers. For there is a second reason for the triumph of indexing, and it is not only more compelling but unarguably universal. I call it the CMH—the Cost Matters Hypothesis—and not only is it all that is needed to explain why indexing must and does work, but it in fact enables us to quantify with some precision how well it works. Whether or not the markets are efficient, the explanatory power of the CMH holds.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

DaufuskieNate
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Re: Ang's Book Helped Me Understand Beta Better

Post by DaufuskieNate » Mon May 11, 2015 8:52 am

JoMoney - Thanks for the very useful and thought-provoking response. Perhaps this is all semantics, but allow me to further explain why my take on this may be a bit different.

As Gene Fama is known for saying, EMH is a model. It's not a law of nature. As a model, it provides a description, albeit imperfect, of how markets should work. To me, the central question is whether this model is useful as a working model. Can it be used to make decisions and establish investment strategies in the real world?

EMH has been described in various degrees of "strength." In its most undiluted, primarily academic, form it is known as Strong Form EMH. In this form, the presence of ANY non-public information is assumed away. While nobody I'm aware of would suggest that this exists in the real world, the principles that derive from Strong EMH are useful. Its much like friction-less models in physics. While they don't exist in the real world, they are still useful in understanding some aspects of how the real world operates, or at least rule out some things that do not work.

Semi-strong EMH basically says that all publicly available information is reflected in prices. If this is not true, then there is at least some profit to be gained if one could discover the mis-priced securities. Of course, the profit would have to exceed the cost of acquiring this knowledge. Databases and computing power today have driven these types of costs down significantly. Its not surprising that most managers are unable to generate sustainable profits in this manner. When its relatively inexpensive to discover mis-priced opportunities, those opportunities are quickly traded on and removed. Low cost information access is a great enabler of market efficiency. The fact that most managers do not beat the market actually lends support to EMH as a useful working model. While semi-strong form EMH may not be a law of nature, in my mind it passes the test of being a useful model of how the market prices securities.

In my mind, one of the foundations of Boglehead principals is that the average retail investor can invest in the market index and actually come out ahead. How can this be the case with so many computers, databases and armies of intelligent minds are on the other side looking for ways to profit from mis-priced securities? The evidence seems to suggest that the cost of chasing these opportunities out-weighs the profit potential - at least for the average retail investor. I think this suggests that EMH holds at least enough to rely on it. Again, perhaps this is just semantics. But to me, a world where EMH is not a reasonable working model is a world where active management makes a lot more sense than indexing.

Mr. Bogle certainly understands that an inefficient market is a challenge to the indexing strategy. I would argue that his poker analogy is not really directly on point. In poker, skilled players earn more over the long run and can be identified. Where are the skilled money managers that consistently beat the market? He also explains that cost matters, which is certainly true. But if the potential gain from active management does not offset the relatively low costs in today's world, can't we also say that the market is "efficient enough" to rely on it as a fair pricing of risk and reward on an ex-ante basis? I think there exists enough evidence of EMH to answer yes. As such, I am in the camp of EMH as a foundational element of indexing as a strategy.

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JoMoney
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Re: Ang's Book Helped Me Understand Beta Better

Post by JoMoney » Mon May 11, 2015 4:47 pm

I don't think anybody argues against the crux of the idea that the market is difficult to beat.
But EMH goes beyond that to say that the only way one can earn a higher return than the market is to take on more risk than the market. Then they try to build models to somehow measure the risk. Then people try to use those models to try and tweak their risk/return.
Beyond the problems with the various methods/models they try to find to measure the risk (that are all backward looking, yet people are pricing the market looking to future expectations), they go off with the idea of increasing risk to increase returns, which might be upside down in an in-efficient market. If risk is defined more along the lines of a reasonable chance that an investment will lose money over a holding period, then it follows that an investor would seek to reduce their risk of losing money if they wanted to increase returns - but EMH says this can't be done, so people who want something more, and treat EMH as if it's truthy, go about following all sorts of strategies that by their own admission are very risky, and think that's the only way to do it. ...But if EMH isn't true, and some people know more about particular investments, they would be earning more by unloading their risky investments on people who know less about it.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Ang's Book Helped Me Understand Beta Better

Post by DaufuskieNate » Mon May 11, 2015 5:23 pm

JoMoney wrote: If risk is defined more along the lines of a reasonable chance that an investment will lose money over a holding period, then it follows that an investor would seek to reduce their risk of losing money if they wanted to increase returns - but EMH says this can't be done
I can think of 2 ways to do this under EMH. One is to diversify with a large number of equities to eliminate idiosyncratic risk. A second is to combine asset classes with uncorrelated risk/return profiles to achieve a re-balancing bonus. Both of these can result in higher returns with a lower risk of losing money.

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Re: Ang's Book Helped Me Understand Beta Better

Post by alex_686 » Mon May 11, 2015 5:35 pm

Random Walker wrote:Trying to read Ang's Asset Management. In describing CAPM, he defines beta very nicely. Previously I had just thought of it as volatility. But apparently it's defined as

(Volatility of asset)(correlation to market) / volatility market.

He calls beta a measure of the Lack of Diversification Potential of an asset to a market portfolio.
So the way I read it, one can achieve low beta with either low volatility or low correlation to the market, and an asset class with low beta should be a very powerful contributor to portfolio efficiency.
Not exactly – you are not using it the way it was meant to be used. Using your definition one can have a low beta and a high volatility.
If I wanted to lower my Beta I could
Invest in low beta stocks – such as utilities, but this actually reduces the diversification.
Increase my cash holdings (lower leverage, low volatility, but the equities would have a perfect correlation with the market.).
Invest in internet start-ups and emerging markets (this would increase diversification).

The first two works– the last one does not. The problem is that I am using the wrong yardstick (S&P 500) to measure my performance (Start ups.) Here is the more traditional formulation:

Total Return = Alpha + Beta

Alpha = Return from Skill – skill in picking stocks, in timing, etc.

Beta = Return from the index. This defaults to the S&P but it does not have to be. If I am reviewing a small cap fund, bond fund, or international fund that I should use a small cap index, bond index, or international index.

FYI, Index funds should always have a Beta of 1 against their chosen index.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.

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Re: Ang's Book Helped Me Understand Beta Better

Post by Yesterdaysnews » Mon May 11, 2015 7:26 pm

While I agree the EMH is an interesting and useful model, there are anomalies which even Fama agrees exists and are difficult to explain.

Fundamentally, behavioral finance always made more sense to me - in that a market exists only due to the presence of human beings who create it, and thus it is built on a foundation of human beings and their innate hard wired programming which includes many episodes of irrational behavior and cognitive biases. The issue is that it's difficult to convert these things into out-performance over the index.

Information is also certainly asymmetrical in the market, just to day I noticed this article :

http://www.bloomberg.com/news/articles/ ... l-time-lag

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JoMoney
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Re: Ang's Book Helped Me Understand Beta Better

Post by JoMoney » Mon May 11, 2015 8:02 pm

Yesterdaysnews wrote:...Information is also certainly asymmetrical in the market,...
One can look at the financial crisis as well. Investment banks were out creating these securities, selling them off to "investors" then betting against the very product they were offering as an "investment":
http://www.nytimes.com/2009/12/24/busin ... d=all&_r=0

You have to decide whether you're a "know-nothing" or "know-something" investor. Warren Buffett has frequently pointed out that a "know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb..."
Benjamin Graham made the distinction as an "enterprising investor" opposed to a "defensive investor", where the chief aim of the "defensive investor" is to prevent themselves from from making serious mistakes and being taken advantage of.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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