This is a guest contribution from my friend Ben Reynolds at Sure Dividend.  Sure Dividend uses The 8 Rules of Dividend Investing to find high quality dividend growth stocks trading at fair or better prices.

Successful investing can be simplified into two aspects:

1. Maximize returns
2. Minimize risk

Point one could not be more straightforward.  The more money you make from your investments, the better.

Minimizing risk sounds straightforward, but in practice it is much more complex.  This article takes a look at the ‘standard’ risk measures in the stock market – and whether they are truly useful in reducing risk.

# Common Stock Market Risk Metrics

The words Beta, standard deviation, and volatility are often used to describe the risk of individual stocks.  These financial metrics are the backbone of stock market risk measurement.

Beta refers to a specific securities’ sensitivity to overall stock market moves. A Beta greater than 1 shows more price sensitivity. If the market declines by 10%, one would expect a stock with a Beta over 1 to decline by more than 10%.  Alternatively, if the market goes up by 10%, a stock with a Beta greater than 1 would see gains of greater than 10%.

Stock price (return series) standard deviation is the most commonly used risk metric. It is calculated as the annualized stock price standard deviation of a given security.  It measures how ‘bouncy’ returns are.  The more big swings there are in the return series, the greater the stock price standard deviation.  Volatility is the same as stock price standard deviation.  It is another word for the same idea.  Volatility and standard deviation are synonymous in investing.

# Fun with Numbers

Everything is a nail to a man with a hammer. Similarly, finance professors like to come up with nice tidy formulas for messy real-world problems. Beta and volatility are proxies for risk. The idea is that riskier securities will see their prices move up and down more.  This means that beta and volatility can measure underlying risk in theory. In the real world, this isn’t true.

Here’s a nice thought experiment:  Imagine you have your pick to invest in 2 different businesses at equal prices. One business makes \$1,000 a year every year like clockwork.  The other business makes between \$1,000 and \$5,000 a year every year. Any rational person would pick the second business even though it has more variability (‘risk’ as academics see it) in its returns. In the stock market, the business that makes \$1,000 a year would almost certainly have a lower beta and standard deviation than the \$1,000 to \$5,000 business because its returns are more ‘stable’.

# What Risk Really Is

Real risk can’t be quickly calculated with stock price data. Real investing risk comes from a permanent impairment (loss) of your investment. When you are investing in businesses (stocks), you can understand risk far better by qualitatively analyzing the business.

Is Coca-Cola (KO) less risky than a biotech startup?  Most certainly.  Can I say it is 3.2x less risky?  No, because qualitatively I know Coca-Cola’s business model is proven, but I can’t put numbers to exactly how less risky it is than an unproven biotech startup.  You can say it is much less risky, however.

Some people like precision and exact numbers.  I certainly do.  But you can’t always have them.  Sometimes using exact numbers leads to worse results because the numbers don’t mean much.

# Warren Buffett Weighs In

Liquid Independence has covered volatility and risk in the past. The article comes to the same conclusion – stock price movement is not real risk.  In the article, there is an excellent quote from Warren Buffett on risk…

Warren Buffett knows a thing or two about investing.  He’s worth well over \$60 billion.  Here’s what Buffett has to say on the matter:

“Volatility does not measure risk. Past volatility is not a measure of risk. It’s nice math, but it’s wrong. If a farm in Nebraska used to sell for \$2,000 per acre, and now it sells for \$600 per acre, investment theory would say that the beta of farms has gone up, and than they are more risky than before. If you tell that to people, they’ll say that that’s crazy. But farms don’t trade daily the way stocks do.

Since stock prices jiggle around, finance professors have translated that into these investment theories. It can be risky to be in some businesses. Risk is not knowing what you’re doing. If you know who you’re dealing with, and know the price you should pay, then you’re not dealing with a lot of risk. We have invested in a lot of sectors that have high betas. The development of beta has been useful to people who want careers in teaching.”

# Where Low Volatility Comes Into Play

Stock price volatility is not the same as investing risk – not even close.

With that said, low volatility stocks have historically outperformed the market. The 100 lowest volatility stocks in the S&P 500 have outperformed the market by an average of 2 percentage points a year for the 20 year period ending in 2011 according to this study by S&P.

This flies in the face of the efficient market hypothesis. Lower risk securities should have lower returns, not higher returns.

I believe that low volatility securities have historically outperformed the market because low volatility is a sign (but not the only sign by any means) of earnings stability.

Businesses like Johnson & Johnson (JNJ), PepsiCo (PEP), and General Mills (GIS) all have extremely low stock price standard deviations – and very stable earnings.  These businesses all have strong competitive advantages as well.

# Final Thoughts

Price movement is not risk.

If you are trying to minimize your investing risk, invest in high quality businesses with shareholder friendly managements trading at fair or better prices.

Volatility (and Beta) can be useful in finding high quality businesses.  Historically, low volatility stocks have done well (on average).

Using low volatility as a tool to find great businesses and then examining their competitive advantages makes sense.  Low volatility is an indicator that a business may have stable operations and a competitive advantage, but it is no guarantee.  It is certainly not risk itself.

You can quickly find low volatility securities by looking at the holdings of the S&P Low Volatility ETF (SPLV).

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