Deviant Behavior and Beta

As promised from last week, now it's time to analyze risk and put some numbers to risk.

We've already discovered the difference between market risk and diversifiable risk, so how do we eliminate risk and what kind of risk can we focus on eliminating?

Well, we cannot eliminate market risk, so we are only left with the possibility of eliminating diversifiable risk. And being a finance geek, I like numbers to help me choose which project is the least risky. Let's look at an example first.

Assume that since you're my friend, I left you $100,000 to invest anyway you see fit and you're left with two possible choices. Choice "A" is to invest in a little stock we'll call "GE." GE has been around 100 years and is very steady and consistent, although not very sexy or glamorous when it comes to a crazy return. You can expect to earn 9% per year from GE.

Choice "B" is a little-known company called "Ola's Tapioca Mine and Tattoo Parlor." The main office is located in Key West, FL and they hope to franchise the concept throughout the country. They, too, expect to give you an 9% return on your investment next year.

So where do you invest and why?

Unless you have a real strong, strange urge for a new tattoo and some tapioca pudding, you will most certainly put your money into GE since there is far less risk and the return is exactly the same as a risky proposition. This is an investors natural reaction to avoid risk and maximize returns and the only way you'd consider "Ola's Tapioca Mine..." is if they had an expected rate of return greater than 9%.

But remember, greater return comes with greater risk. Let's call this risk "BETA."

Now let's also assume that the stock market has a BETA of 1.00, and we know that the average return in the stock market is about 9%. We need a number to show how much more, or less, risk is associated with our investment.

GE is old and consistent. When I hit YAHOO Finance and checked out their key statistics, their BETA was .75. This means that for every 1% the stock market moves up or down, GE will move 75% of the distance. So, if we expect the stock market to go up 10% next year, we would expect GE to go up 7.5% next year. Similarly, if we expect the stock market to go DOWN 10% next year, we'd expect GE to go down only 7.5%. So while our expected rate of return is the same as the stock market, our risk is actually 25% LESS. Hmmm..

Our Tapioca Mine might have a BETA of 1.5. This means that if the stock market went up 10%, we'd expect the Tapioca Mine to go up 15%, and vice versa if the market went down. In essence, our investment is 1.5 times riskier than the stock market and offers only a similar return. Not good.

There is a different figure we can use as well that capitalizes upon standard deviation, but that's not necessarily a blog type of entry. I just want you to be comfortable when you see the term BETA Coefficient going forward and recognize what it means.

Also recognize that BETA is utilized to compare projects that you are considering as a business, along with standard deviation and coefficient variation. If you'd like help with any project analysis, including PERT charts, please let me know as I have experience in these things and would be delighted to assist you.

Finally, recognize that you can get most of these figures for free from YAHOO Finance, CNNFN, etc. Research doesn't have to be expensive or time consuming.

Former Magellan Fund Manager and investing legend Peter Lynch often said his best source of research was his wife and his teenage daughters. They knew retail trends and hot fashion better than a 50-year old investment fund manager, so he learned to trust their judgment on what was hot and what was not. He simply put pen to paper to see if the numbers made sense, which they often did.

Use your common sense when looking at investment choices. Many times, you know something the pros don't or something they miss in their analysis; something you can use to make a lot (or save a lot) of money.

Next up: Positive and Negative Coorelation (not much of a teaser, but certainly a reminder to me of what the heck to write next week.)

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Bailing More than Water

Well it's been one of those weeks in the economy. And while I attempt to stress the importance of everything to my students, I can't help but wonder if any of them get it.

The reality of the situation is very simple: our federal government is bailing out private enterprises faster than Homer Simpson can dunk a donut. It concerns me beyond compare.

To date, the feds have stepped in and assisted Lehman Brothers buy out Bear Stearns, and they've also taken over Fannie Mae and Freddie Mac. As of this writing, there is speculation that they might assist an entity buy out Lehman Brothers. Yes, the same Lehman Brothers that just purchased Bear Stearns about six months ago. The automakers are also asking for $50 billion in government handouts (fortunately, they will probably only get $25 billion.)

Throw in an election year with two candidates that desperately want to win, and it's evident our federal reserve system is really just an ATM (except they don't get to keep the $2.00 fee each time.)

I'm not going to argue whether or not the economy is in dire straits. It is. I don't need Ben Bernake to tell me that and my students don't need me to remind them that their dollar is worth about $.85 compared to last year. That's called inflation.

What I am going to argue, however, is this: I don't think the government should step in and bail ANYONE out - ever.

Get your pencils out for this terribly complex economic/financial formula. Risk = reward. Whew. Got it? Good. Repeat after me. Risk = reward.


So I have to ask you this. Where is the risk to start and mismanage a business if you know the government is going to come in and save the day?

And make no mistake about it. Each of the companies seeking goverment assistance has been horribly mismanaged for years, not just the last few months. Fannie Mae and Freddie Mac epitomize mismanagement, providing deep pockets for Wall Street while simultaneously spending in excess of $150 million in lobbying during the past decade. There is a reason prices of housing escalated so quickly - both agencies allowed consumers to qualify for loans they couldn't afford, with debt ratios in excess of 50% of a homebuyers GROSS income. Think about that for a moment. You make $4000 per month before taxes, utilities, groceries, car insurance, etc. and Fannie Mae tells you to go ahead and take that $2000 per month payment. Where does the rest of the money go?

Throw in the fact that you could purchase a home with $0 down payment (as in ZERO) and you have a recipe for disaster. Nevermind the fact that often the buyer had impaired credit and the seller was paying part, or all, of the closing costs associated with the transaction. Appraised values were inflated, inspections were skewed and sometimes even the real occupancy of the owner came into question. Oh, and everyone made gobs of money.

Even my first year business student recognizes the flaws in this business model. Mismanagement 101, my friend.

So I return to my basic question. Are you willing to kick in the $10-15 BILLION required to bailout Fannie Mae and Freddie Mac?

To be sure, GMAC isn't exactly the model of efficiency and Lehman has been called "greedy" from time to time. They, too, are asking for help.

For argument sake, recognize that we are spending about $10 billion per month on the war on terror in Iraq. Should we rob Peter to pay Paul? That's what we're doing.

How do you pay for these bailouts? There are two ways and neither one is a good option.

1. Alternative revenue sources (political speech for "raise taxes.")
2. Print more money since the value of Treasury Bonds will run more risk than current yields support. If this occurs, something called Hyperinflation will occur and yes, that's worse than it sounds.

There is an answer and it is a painful one.

Allow the markets to take care of themselves. Penalize Fannie, Freddie, GMAC, Lehman and any other company that fails due to mismanagement by letting them become extinct. Yes, it will hurt - bad. But investors will learn their lesson and adjust accordingly. If they don't, they will risk losing on their next investment.

The message being sent right now is "too big to fail." Tell that to Enron, MCI/Worldcom, Adelphia. On the flip side, is Microsoft too big to succeed? We try to break up successful models, calling them a monopoly. Where is the fairness? Is Wal Mart next to be broken up, or are they better of simply running themselves into the ground too?

Risk = reward. If you take big risks, you are entitled to big rewards - or big losses.

You cannot regulate risk any better than you can regulate deman; something communist countries discovered through the black market. And while I don't want to insinuate that we are heading toward communism, we are certainly further away from a free market economy today than we were a mere ten years ago.