Self-fulfilling Betas

Good evening (again),


This actually follows on from something I wrote a while ago:

http://themaskedaimtrader.blogspot.co.uk/2014/09/understanding-and-rethinking-financial.html


A recent trend amongst many analysts has been to add something called a "small cap premium" to their beta calculations.

This takes the usual beta calculation of running a load of regressions, taking the gradient of these and then making a beta, but in this case, there is the bizarre additional step of adding a premium because the company is small.


Now, I'm not necessarily against this, but when it's done with a lack of explanation it can be highly annoying and has a tendency to wind me up, because it then requires that your thinking is parallel with that of the analyst's work.

In some cases, it's actually a pretty good idea, because large or small free floats for example, have the potential to effect your practical beta in the event of market worry or crisis, but this does have to at least be stated if you're going to trust the beta calculation you're given.


The bit that's very intriguing though is the idea that a financial beta could actually be self-fulfilling, especially on AIM where the private investor dominates the field.


This requires you making the general assumption that most people only care about betas in times of financial worry - no one is going to care about their portfolio's beta risk when the market is up forty percent.

If we assume that this is true, then a perceived increase in a company's reported beta (because it's given a "small cap premium") then results in a greater sell off when market turmoil increases, as a result of people actively trying to reduce the beta risk in their portfolios, leading to this increase in the beta to be fulfilled and represented.

In short, adding another point here or there has the potential to have a psychological impact large enough to cause the unbacktested or partially hypothetical betas to actually self-fulfill the values set out by the analyst who calculated the beta.

In essence, I say the beta of an asset is higher than it's baseline beta, so in periods of market worry private investors move from this asset to an asset with a lower beta, thus fulfilling in practical terms my increased beta calculation.


I think that the message here is to question figures you're ever given and check that they're in tandem with your investment strategy.


The masked AIM Trader.