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:
- Maximize returns
- 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.