Island Investing: Risk, Take Two

My column in today’s Keys Weekly.

Q. How should I think about risk when investing in stocks?

A. Risk is a highly theoretical, strongly debated topic when it comes to investing. I wrote a partially tongue-in-cheek answer to this question last fall, but I’ll try again without the lame humor.

When it comes to investing in stocks, Wall Street and academia have traditionally described risk using a metric called “beta,” which quantifies the movements of a stock’s price compared to both the market as well as the price of other stocks. The general rule of thumb is that a beta greater than 1.0 means the stock will fluctuate up and down more than the broader stock market, while a beta lower than that threshold means it will fluctuate less – or even in the opposite direction. By this logic, high beta stocks are riskier, and low beta stocks are safer.

Here is the problem with that approach, however. It measures the fluctuation of stock prices, not business value. Rational investors should not be concerned with stock price changes – except when you can take advantage of them. The only thing that really should matter is how the stock price compares to the long-term value of the business.

Relying on beta can fly in the face of common sense. For instance, Google shares had a higher beta at $260 per share at the end of 2008 then at $700 per share at the end of 2007. Now, I ask you…when was the riskier time to buy?

To value investors, beta is useful only when it confirms something you probably already know – that the stock price is volatile because the company’s long-term prospects are, too. Otherwise, I think it’s better to think of risk in common-sense terms. Specifically, what are the odds that you’re going to lose all of your money, or see a permanent decline in your investment?

You should attempt to minimize that kind of risk every way possible – starting with sticking to companies with clear and consistent future prospects. But you’ll miss some great investment opportunities if you confuse volatility in stock prices with real risk.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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