In a nutshell, beta is a measure of how much more or less correlated a particular stock is in relation to an index, and the index is typically the S&P 500. Unless you're a statistician, the formula isn't important. Just understand that the average beta is 1.0. Of course, the S&P 500 is a fair proxy for the 'average' stock, so the S&P 500 beta is also 1.0. If a stock's beta is 1.0, then the correlation between that particular stock and the overall market - and measured buy the S&P 500 - should be very high. In fact, if the beta stays at 1.0, then the correlation is essentially perfect. This means that (and please allow for a realistic degree of variation) whether the market is moving up, down, or flat, then the stock in question will be matching the market's movement on a percentage basis. If the beta is 2.0, then the stock will move by twice as much as the market, whether it be up or down. And, if the beta is 0.5, then that stock will move half as much as the index does.

Now, this isn't a statistics lesson. If you want to dive into the details of beta (and I don't), you should be able to find a lifetime's worth of reading on the internet. The important part is that you understand the rationale behind the use of beta. In a bullish environment, stocks with a higher beta offer a little more reward. Stocks with a lower beta don't offer as much of an opportunity for gains in a bull market, but they also limit the overall volatility.....and make it easier for an investor to stomach any major market swings. In a bearish environment, high beta stocks fall further and faster, where low beta stocks don't suffer quite as badly as the overall market. See, it's all a trade-off. If you're an investor who has adequately defined your risk tolerance, holding periods, and strategy, then adding beta to your equation can clearly enhance your returns, and/or limit your downside exposure.

But as was asked above, is it worth it? The answer was yes, and no.

Like a firearm, beta is powerful and useful if you know how to use it. If you use it improperly, it's a danger to you and to others. That's a rather melodramatic analogy, but it's also an accurate one.

Where I see most investors getting tripped up with beta is not beta in itself - it's they way they think about beta within the framework of their philosophy. In most cases, I hear clients tell me they seek out lower beta stocks because they don't want go through a great degree of pain if the market turns sour. That's fine; that's a practical use of beta. But in most of those cases - although a few months later - I hear the same folks looking back at a major market rally, and lament the fact that they underperformed. The next most common beta mistake (and it's a close second) is just the opposite. An investor will load up with high beta stocks, and then ride it out when things get ugly for the market. Of course, their losses are magnified.

In their defense, it's easy to let either one of those things happen. These investors are just doing just what they've typically been told to do. Unfortunately, they may not have been told everything they needed to know.

To get the most out of beta, you absolutely have to define your strategy, your exit point, and your opinion, before building a stock portfolio. High beta stocks were a dream in the late 90's, when the market was going higher. In fact, that was the right time to specifically seek out high beta stocks. Beginning in early 2000, it was wrong to own high beta stocks.....dead wrong. Unfortunately, most players owned them anyway, and rode them down way too far. The mistake wasn't a high beta portfolio. The mistake was a high beta portfolio in what should have clearly been defined as an omen of a bear market. In other words, the strategy was undisciplined, and the opinion was wrong. Volatile stocks weren't the main cause of catastrophic losses. Owning those volatile stocks were the cause of catastrophic losses.

Don't be offended by that. It's not a judgment of character or intelligence. A lot of Wall Street pros were suffering just as much as the average investor was. It was just a case of euphoria leading to unrealistic expectations. At the beginning of 2000, we were about five years overdue for a bear market. The bear just made up for lost time, while most of us were stunned, having forgotten what a bear market was.

So what's a functional use of beta? You probably already guessed it. High betas are great in a bull trend. But when things get rocky, you really can't afford to be in anything except low beta (and negative beta) stocks. The challenge lies between an investor's ears. Are you willing to make that change when the time calls for it? We're under no illusion that it's easy to spot the transitions from one environment to the other. Believe me, it's tough to do. We do, however, have the discipline to act when the transition becomes obvious. For us, one of those obvious signals is simply a cross under the 200-day or 250-day moving average line. That's about nine to twelve months worth of moving average, although not necessarily nine to twelve months worth of losses before we finally pull the plug on high beta stocks. In general, the indices fall under the 200-day and 250-day line about 60 or 70 days after things get sour. That means we have to suffer about three months of weakness before we're convinced the bull market is taking a break. You could set up your own bull/bear methodology and get similar results. The question is, will you?