Beta: Know The Risk

Re-Assessing Risk

The well-worn definition of risk is the possibility of suffering a loss. Of course, when investors consider risk, they are thinking about the chance that the stock they buy will decrease in value. The trouble is that beta, as a proxy for risk, doesn't distinguish between upside and downside price movements. For most investors, downside movements are risk while upside ones mean opportunity. Beta doesn't help investors tell the difference. For most investors, that doesn't make much sense.

There is an interesting quote from Warren Buffett in regards to the academic community and its attitude towards value investing: "Well, it may be all right in practice, but it will never work in theory." Value investors scorn the idea of beta because it implies that a stock that has fallen sharply in value is more risky than it was before it fell. A value investor would argue that a company represents a lower-risk investment after it falls in value - investors can get the same stock at a lower price despite the rise in the stock's beta following its decline. Beta says nothing about the price paid for the stock in relation to its future cash flows.

If you are a fundamental investor, consider some practical recommendations offered by Benjamin Graham and his modern adherents. Try to spot well-run companies with a "margin of safety" - that is, an ability to withstand unpleasant surprises. Some elements of safety come from the balance sheet, like having a low ratio of debt to total capital. Some come from consistency of growth, in earnings or dividends. An important one comes from not overpaying. Stocks trading at low multiples of their earnings are safer than stocks at high multiples.

In Summary

It's important for investors to make the distinction between short-term risk - where beta and price volatility are useful - and longer-term, fundamental risk, where big-picture risk factors are more telling. High betas may mean price volatility over the near term, but they don't always rule out long-term opportunities.

Ben McClure can be contacted at BayofThermi.com