How to Manage Your Money: Know your Beta
In the investing world there is a number known as “beta”. Investopedia defines beta as follows:
A measure of a security’s or portfolio’s volatility, or systematic risk, in comparison to the market as a whole. Also known as “beta coefficient.”
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta less than 1 means that the security will be less volatile than the market. A beta greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2 it’s theoretically 20% more volatile than the market. (emphasis added)
The other day I was studying something entirely unrelated to personal finance when the concept of beta jumped into my head. Only this time, I wasn’t thinking of beta as relating to a stock, I was thinking of beta as it relates to how to manage your money.
I’m not talking about a fund manager asking himself how to manage your money. I’m talking about you asking yourself that question.
Notice the bolded part of the quote above: “you can think of beta as the tendency of a security’s returns to respond to swings in the market”. Let’s replace a few words and restate it:
You can think of beta as the tendency of your finances to respond to swings in life..
What’s your personal beta?
Nobody wants a personal beta that deviates far from one. It causes stress on the job, at home, in your marriage, family, and other relationships. It can possibly keep you in a job you don’t want, doing something you don’t like, for people who treat you lousy.
The best way to move your personal beta toward one is to set up a personal budget. A budget reduces risk in your personal finances. It smoothes your income and expenses, and decreases the height of the crest and depth of the trough in the financial waves that may bear down upon you.
A budget is a benevolent dictator when it comes to how to manage your money. It is firm when it feels its power being taken from it, but it will also give you some slack – when asked politely.
Did you notice the term “systematic risk” in the definition above? Let’s go into that a bit deeper with another definition:
The risk inherent to the entire market or entire market segment. Also known as “un-diversifiable risk” or “market risk.”
In order to apply this to your personal finance situation, we’ll alter the definition again slightly:
The risk inherent to your finances or entire life. Also known as “un-budgetable risk” or “uncontrollable risk.”
This is a fancy way of saying its the risk of living day to day. It’s the risk that will always be there no matter what you do. You’ll notice as you learn how to manage your money better and better that your personal beta does go down – it gets pretty darn close to one if you really work on it. You’ll notice an improvement from your former, volatile self. This is the unsystematic risk that has declined. It is also sometimes called “specific risk”. And it’s something particular to you, that can be taken care of if you learn how to manage your money a little better – bring things in a little tighter – pay a bit of heed to that benevolent dictator.
However, even the best money managers cannot get rid of risk entirely. No matter how you manage your money, you will still be subjected to the systematic risk of life. You cannot reduce it. You cannot ignore it.
Before you get down on yourself, or maybe even feel a bit depressed about this supposed risky situation that you live in, let me assure you of one thing: Unsystematic risk makes up the large, large, bulk of the stress you may feel when you’ve slacked on your money management. The systematic risk inherent in life is small – tiny – minute. When your personal beta is one, you are feeling good! Life is good! The grass is green! The sky is blue! On your side of the fence!
The budget will show you how to manage your money. It will show you how to reduce your unsystematic risk to nothing. It will get your personal beta down to one. It is the solution to money management stress and worry.
What’s your personal beta?