Life is Good When You’re a “Zero.”Posted on — Leave a comment
Want to relax and enjoy life for a change? Try becoming a zero.
A zero-beta asset is one that has no systematic risk.
Simply put, systematic risk is the risk that’s common to all investing. Therefore, it is sometimes called “undiversifiable risk.” You cannot escape it. If you want to play the game, you have to step on the field.
Except when you don’t.
Research from the University of Oklahoma shows that “gold bullion adds no systematic risk to an investor’s portfolio.” Therefore, it is a zero-beta asset. Beta is a number that reflects an asset’s risk compared to the general risk of the entire market.
An asset with a beta of 1 moves exactly as the market does. An asset with a beta of 1.1, for example, is 10% more volatile than the broader market. An asset with a beta of 90 is 10% less volatile than the total market. Beat is a useful number for investor because it tells you how much more, or less, volatile an asset is in comparison to simply “buying the market” with an S&P 500 index fund.
The researchers’ analysis shows that gold’s beta “is statistically indifferent from zero.” This finding means that the researchers believe that gold is not exposed to market volatility. As they explain, gold is “virtually uncorrelated with stock returns,” and “bears virtually no market risk, yet has a positive risk premium.”
That detail is important for anyone looking to minimize the total risk profile of their portfolio. Unfortunately, not nearly enough people realize that they need to reduce the risk within their portfolio.
In a recent article in the Wall Street Journal, author Jason Zweig explores how poorly most investors assess risk. We forget painful lessons. We dismiss important information when it doesn’t agree with our expectation. Perhaps our thinking hasn’t evolved fast enough to keep up with the relatively modern invention of money.
Harvard economics professor Andrei Shleifer explains that “The extent to which people’s expectations of future stock-market returns track the past 12 months of returns is astonishing.” Most investors don’t consider enough of the risks. At the same time, they overemphasize the rewards.
This irrationality has spread through the entire financial market. Other researchers, published in the Journal of Economic Perspectives, prove the existence of this irrationality by explaining that “asset markets exhibit trading volumes that are high, with individuals and asset managers trading aggressively, even when such trading results in high risk and low net returns.”
Just like systematic risk, there’s no escaping irrationality. You might be aware of it, but you cannot avoid it. To be irrational is to be human. However, you can minimize it with zero-beta assets.
As part of a diverse portfolio, zero-based assets like gold help investors get out from under an irrational market. Too many buy and sell transaction governed by emotion rather than logic. The equity bull market of today has become the longest in the history of investing. The work of economists and social psychologists shows us that these stock valuations reflect more than underlying value. They reflect exuberance.