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.

About a year ago I bought some HVU.TO. It was my first time dabbling in the futures market and it was quite risky. The HVU, or Horizons BetaPro S&P 500 VIX, is an ETF that tries to double the gain or loss of the VIX index which is a benchmark for volatility in the stock market. Normally when the stock market is doing really well like right now the VIX index is low because investors don’t think stocks will fluctuate very much in the near future. But in 2008 and 2009 when stocks were low the VIX was high because there was a lot of uncertainly in the markets. Buying into volatility is a way to minimize portfolio risk lest the stock market decides to take a dive.  I bought about 180 shares of HVU in February last year. Total purchase price was worth about \$2000.

When I bought the HVU back in early 2012 I thought I could make a quick swing trade but instead of selling when I could have made a small profit I decided to wait for it to go higher. Well that was a mistake because soon I was losing money and the price never came back up. By being too greedy and missing my opportunity to sell I ultimately lost out (>_<) I checked my balance today and was less than impressed with how the HVU have performed over the last year.

Apparently it’s lost 98% of its value since I bought it and I’ve lost almost all my initial investment of \$1979.19. The reason the quantity says “4” instead of my original “180” shares is because it went through a 1:10 split and then another 1:4 split *sigh* (ーー゛). Even if it goes back up 10 folds now it still won’t be worth very much. So earlier today I put in a sell order of all my HVU holding. Since markets are closed today the sell order will automatically be executed first thing on Monday morning 🙂

Initial Investment: \$1000. Leveraged up to \$1969.20 by borrowing \$969.20 on margin at 4.25%.

Feb 15st, 2012
Bought: 180 shares of  HVU.TO at \$10.94/share = \$1969.20
Today, Mar 16th, 2013
Sold: 4 shares of HVU.TO at \$8.68/share = \$34.72
Difference: -\$1934.48

Expenses:
Commission: 2 trades x \$9.99 = \$19.98
Margin interest: \$44.62

Net loss after expenses: \$1999 (pre-tax)

One myth about investing in the stock market or any other market where prices fluctuate is that it’s risky. But people who know how to value a stock understand that it doesn’t have to be risky if they buy the right stocks at the right time. Volatility and risk aren’t always correlated. Some companies with steady growth such as Enbridge have been pretty stable over the years.

That’s not to say ENB is a good buy today because whether a stock is reasonably valued or not is another topic. But here’s a look now at Caterpillar below, who manufactures construction equipment, heavy machinery, etc.. Notice how the stock is more volatile over the same period as Enbridge.

But that doesn’t necessarily mean CAT is a riskier stock than ENB.  CAT is a more cyclical company so its Beta is suppose to be higher. What makes a company safe to invest in for myself is a positive trend of earnings growth, dividend growth, and industry expansion. Both companies have had stable dividend growth over the last decade meaning managers are confident about their company’s future performance. Both companies have also increased their profits over the years. Pipeline companies are looking to expand their pipes across Canada, and In Alberta alone the government has forecast there will be 114,000 jobs in the construction industry over the next decade (o.O) ENB and CAT are both in growing industries with growing demand for their products/services.  Stocks can vary in risk depending on what kind of business they are, but volatility doesn’t necessarily mean risk. It just means at some point in time, there might be  a good opportunity to buy the stock at a great value 😉

Here’s what the Oracle had to say on the subject….

“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.”
– Warren Buffett

Beta – The measure of volatility. Higher beta = bigger fluctuations in price. The overall market has a Beta of 1. If a stock is said to have a Beta of 1.5 then that means it will be 50% more volatile than the market.

Another swing trade? Where did this come from? Well this is a very unusual situation.

In our first swing trade we used the volatility index to correctly predict that the markets will become less volatile and move up. But yesterday as I was glancing over my watch list I noticed the VIX was really low (around 18.6), which means at some point it will probably revert back to its mean of around 20 to 30. So how can we take advantage of this opportunity? One way to play volatility is the Horizons S&P 500 VIX Short-Term Futures: Bull Plus ETF. Or, HVU on the TSX. It’s a long name, but the HVU is basically an ETF that tries to double the returns (or losses) of the VIX. In other words, if the VIX goes up 10%, then HVU should go up 20%. However, a 10% drop in the VIX means a 20% drop in the HVU.

So earlier this morning, Friday, Feb 10, I bought some HVU. Luckily, last month between working 2 jobs and my investment income I was able save more than \$1,000 after paying for all my living expenses. So today, I used \$1,000 of my own savings, and borrowed another \$1,000 from my line of credit, to buy roughly \$2000 of HVU.  This means half the money is my own, and half the money I’ll need to return once I sell the shares later. Details below.

Initial investment = \$1000

Leveraged up to \$1969.20

Bought 180 shares of  HVU.TO  at \$10.94 CAD = \$1969.20

I say this is a very unusual situation because normally I don’t swing trade unless I know there’s a pretty good chance (above 70%) that I’ll make money. But today I’m only about 60% sure I’ll make money, and 40% I’ll lose money (>_<) . But the reason I’ve decided to do it anyway is because betting on increasing volatility is also a hedge against the overall market. So even if I lose money with this swing trade, my buy and hold investments, which represent 90% of my portfolio will probably go up because these two types of investment instruments have a negative correlation to each other!

My exit strategy? If the HVU goes up by 10% to 30% I will sell it and take profits. If it drops by more than 50% then I might sell it and take my losses. This is the riskiest gamble I’ve made so far with my swing trades. I’m basically using leverage on top of leverage, lol.

Do NOT try this at home if you don’t understand all the risks involved. Like I said, I am willing to lose 50% of my holdings, which is about \$1,000 of my hard earned cash on this because I think the potential for profit outweighs the dangers. But hey, who knows.Maybe this will be my first swing trade where I’m actually going to lose money（　ﾟ Дﾟ）. I guess only time will tell. Isn’t this exciting? (^_^) Stay tuned in the weeks to come.