Use beta to ride the next rally

By Jim Jubak

Are you getting enough beta? (And I don't mean carotene).

If you believe that all the ducks are lining up for a good fourth-quarter stock market rally, as I do, then you ought to be adding beta to your portfolio. Nothing is guaranteed in investing, of course, but adding a teaspoon or two of beta to your portfolio at a time like this is a good way to make sure that you won't miss out on the upside of an impending rally. Too little beta and you'll lag behind any rally.

So what is beta, anyway?

Two things account for the returns on a portfolio, according to current financial theory. There's beta, the part of a portfolio's return that comes from the direction of the general market, and alpha, the part of a portfolio's return that results from an investor's skill in market timing and stock picking. (I'll have more to say about alpha in my next column, which will give you five specific stocks to buy for the rally.) You can find the current beta for any stock on its detailed quote page on MSN Money. You'll see beta near the bottom of the second column of figures.

A way to assess volatility

Beta is a measure of a stock's volatility in relation to the market as a whole. By definition, the market is usually represented by the S&P 500 ($INX) and is assigned a beta of 1. The higher the beta, the more the stock goes up when the market heads up and drops when the market heads down.

During the September rally, when the S&P 500 climbed 2%, Walt Disney (DIS, news, msgs), with a beta of 1.1, returned 4%, and AT&T (T, news, msgs), with a beta of 1.43, returned 5%. (But remember that beta is only part of performance: McDonald's (MCD, news, msgs), with a beta of 1.29, returned 9% in September.)

And it makes sense that during the late spring-to-early summer downturn in the market -- May 5 through June 13 -- when the S&P 500 fell 8%, Intel (INTC, news, msgs), with a beta of 2.21, fell 12%, and Nvidia (NVDA, news, msgs), with a beta of 4.01, fell 37%.

Low-beta stocks are less volatile than the stock market as a whole. That's good news during a market downturn. A low-beta stock such as Wells Fargo (WFC, news, msgs), with a beta of 0.36, fell just 3% during the spring downturn that took the S&P 500 down 8% and PepsiCo (PEP, news, msgs), with a beta of 0.59, broke even with a 0% return in that market tumble. But it's not so good during a market rally: During the September rally, PepsiCo lagged the 2% return on the S&P 500 with a 0% return.

Why beta matters

I can think of three reasons why all this finance stuff about beta is important to the average investor.

Beta strips the hype out of performance numbers. Which money manager did a better job: the one that earned a 24% return in 2003 or the one that delivered 8% in 2005? Focusing on beta reminds you to subtract the market return in looking at any performance numbers. The money manager who returned 24% in 2003 actually cost his investors money that year: The S&P 500 climbed 26.38%, so the manager underperformed by 2.38 percentage points. The money manager in 2005 did a whale of a job since he beat the market's 3% return that year by 5 percentage points.

Of course, that doesn't stop the money manager who underperformed in 2003 from trumpeting that return in ads. Thanks to beta, you, unlike so many investors, understand exactly how empty that claim is. And you understand that it's not worth paying a cent in management fees for that kind of performance.

You can earn the market return -- the return that comes from owning a portfolio with a market-matching beta of 1 -- very cheaply: A low-fee index fund such as the Vanguard 500 Index Fund (VFINX) matches the market and delivers beta returns for a minuscule 0.18% in fees.

Beta helps me control risk. Jubak's Picks underperformed the S&P 500 by 5 percentage points in the third quarter of 2006. I'm not happy about that, but I understand why I lagged the market. Looking ahead at the historically weak mid-August to mid-October period, I decided to lower the beta of my portfolio by allowing my cash position to increase, by staying over-weighted in low-beta gold, oil and natural resource stocks, and by adding low-beta consumer stocks such as Johnson & Johnson (JNJ, news, msgs) and Proctor & Gamble (PG, news, msgs) with betas of 0.29 and 0.23, respectively. In what I regarded as a higher risk period, I decided to limit the volatility of my portfolio to cut my risk. I hoped that my stock-picking (the alpha part of my return) would give me positive results for the quarter even if the market didn't.

Of course, it didn't work out that way. The market rallied and left my low-beta portfolio in the dust and my stock picking turned out to be a mixed bag with my gold and energy stocks producing losses that completely offset my gains from my consumer and financial stocks. (For a full report on my third-quarter performance with short- and long-term numbers, see the update section at the end of this column.)

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