Monday, June 18, 2012

Economics 101: The Power of Beta

I once took a Finance class during my MBA program in which the professor asked the students if they knew what the beta (or risk) of their investment portfolio or 401K was.  He was happily nodding his head in approval for two reason; 1.) he knew it is usually almost impossible to know what beta of your portfolio is, and 2.) he knew most of the students didn't even know what beta was.  Now being a good little P-Money that I was, I rose my hand and said "mines 1".  He was shocked and congratulated me on my financial success.

Now, what the heck does all that mean?  Well, the beta score of a given stock or portfolio is essentially a measurement of risk in terms of the overall market.  You see, the Dow Jones Industrial Average or the S&P 500 (you might have heard these being quoted on the nightly news) are each a collection of stocks that serve to mimic the US economy.  We therefore establish that the risk of the overall US economy is 1.  Now say you owned stock in Google (who so kindly hosts my humble blog).  If you were to look up its beta , it hovers around 1.08 which means that the stock is approximately 8% more volatile (or risky) compared to the overall US economy.  Likewise, if a stock was 0.9, than it is 10% less risky or volatile than the US economy.  Now let's look at an economic model called the Capital Asset Pricing Model (or CAPM).

The above model describes a relationship between a return on a portfolio and the subsequent risk.  The tangency point is the point where the market risk and return line up.  Generally speaking the S&P has returned somewhere between 8% and 9% per year.  Now the efficient frontier is the absolute best a portfolio can get.  The yellow dot towards the top of the red line indicates a portfolio where the return is higher but takes on far more risk.  If it were to be above the line, more people would invest in it, the portfolio would become sluggish and migrate back towards the red line.  

Now how does this relate to me?  Well, this type of information is very important when choosing what type of fund to use in a company 401k.  Usually a company will offer a series of funds and then some kind of index fund.  I highly recommend choosing the index fund for two reasons; 1.) You will almost never find a portfolio that has a higher return for the relative risk, and 2.) the expense ratio is minuscule.  In case you didn't know, the expense ratio is how much it costs to manage your fund.  Some more managed funds are 1-2% which means they take away 1-2% of your return each year.  A general index fund is usually around 0.05% making it well worth the value.

Now that you know a little bit about beta, you can wow all your friends and tell them P-Money is awesome!!!...just kidding.

Wonderful Moment of the Day = Lying in the grass with my wife and looking up at the planes as they fly bye.

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