The Chances You Take In Owning Stocks
In the great bull market of the late 1990's, the definition of risk seemed easy. It was the danger of not keeping the bulk of your capital in hot stocks that could triple in a year. Today however, there are a lot of investors who define risk as owning any such stock. Both perceptions unfortunately are symptoms of "herd mentality" and both can lead to disaster.
Among academics and analysts there is yet another formula called beta, and it's as bad as the two mentioned above. Beta is a statistical measure of so-called systemic, or market-related risk. It is not as popularly believed, strictly a measure of volatility.
One needs to question strongly what this statistic is supposed to be telling us. The theory is that high-beta stocks are riskier than low-beta ones, but reward you with better returns over the long run.
Well, the truth is that they don't deliver those returns. Eugene Fama, one of the early apostles of the efficient market theory built around statistics like beta, renounced his faith in this yardstick. In a paper he co-authored with University of Chicago colleague Kenneth French in 1992, Fama found that no correlation existed between risk and return. In Fama's words, "Beta is dead."
What else is there? Well, there is a more direct measure of volatility - namely, standard deviation of daily/weekly/monthly returns. The standard deviation will tell you whether a stock jumps around a lot, but it scarcely gets at more fundamental matters of risk such as: Is there a risk that the industry you are investing in will not exist in ten years? Is there risk that you are caught up in a speculative bubble and are paying ten times what the stock is worth? Neither beta nor volatility comes close to capturing risks like these.
If you want to assess risk, think about the big picture. Think about things like these:
A company's financial strength. Does it have a strong ability to sail through tough times? If you buy a group of pharmaceutical or tech stocks with enormous financial muscle, you will have a very small chance of losing your investment due to financial problems. Therefore, pay a lot of attention to balance sheets.
The price in relation to the fundamentals. There is always the risk of paying too much for even the soundest business. Buy stocks at or below market multiples--of price to earnings, to book value or to cash flow (in the sense of net income plus depreciation). Some value managers like these ratios to be in the lowest 20% of all stocks.
Inflation. In his book Stocks For The Long Run, Jeremy Siegel showed that stocks significantly outperformed Treasury obligations over the past 195 years. And the gains of stocks over T-bills increased enormously in the post-World War II period.
Why is that? Because inflation, which was minimal before the war, rose sharply over the next 50 years.
An investor who held T-bills, the supposedly "riskless investment," between 1946 and the century's end would have had a real pretax return of only 0.4% annually. Stocks, on the other hand, would have returned 8%. Long-tern Treasury bonds, by the way, scarcely did a better job than T-bills in keeping up with inflation.
Compounded over a working lifetime of 40 years, the spread between an 8% return and a 0.4% return is enormous--almost 19-to-1 in the purchasing power you have at the end of the period. Now think about this risk: the risk of earning too little and having to retire in penury. For young savers that's a much more consequential risk than the risk of losing money in a stock over the next year.
Back before the tech wreck occured, millions of investors had persuaded themselves that there was no risk of overpaying for a Cisco or a Yahoo because tech stocks always bounced back. Today, the same people have persuaded themselves that all equities are too risky. Both views are very wrong!
* * * * *
Among academics and analysts there is yet another formula called beta, and it's as bad as the two mentioned above. Beta is a statistical measure of so-called systemic, or market-related risk. It is not as popularly believed, strictly a measure of volatility.
One needs to question strongly what this statistic is supposed to be telling us. The theory is that high-beta stocks are riskier than low-beta ones, but reward you with better returns over the long run.
Well, the truth is that they don't deliver those returns. Eugene Fama, one of the early apostles of the efficient market theory built around statistics like beta, renounced his faith in this yardstick. In a paper he co-authored with University of Chicago colleague Kenneth French in 1992, Fama found that no correlation existed between risk and return. In Fama's words, "Beta is dead."
What else is there? Well, there is a more direct measure of volatility - namely, standard deviation of daily/weekly/monthly returns. The standard deviation will tell you whether a stock jumps around a lot, but it scarcely gets at more fundamental matters of risk such as: Is there a risk that the industry you are investing in will not exist in ten years? Is there risk that you are caught up in a speculative bubble and are paying ten times what the stock is worth? Neither beta nor volatility comes close to capturing risks like these.
If you want to assess risk, think about the big picture. Think about things like these:
A company's financial strength. Does it have a strong ability to sail through tough times? If you buy a group of pharmaceutical or tech stocks with enormous financial muscle, you will have a very small chance of losing your investment due to financial problems. Therefore, pay a lot of attention to balance sheets.
The price in relation to the fundamentals. There is always the risk of paying too much for even the soundest business. Buy stocks at or below market multiples--of price to earnings, to book value or to cash flow (in the sense of net income plus depreciation). Some value managers like these ratios to be in the lowest 20% of all stocks.
Inflation. In his book Stocks For The Long Run, Jeremy Siegel showed that stocks significantly outperformed Treasury obligations over the past 195 years. And the gains of stocks over T-bills increased enormously in the post-World War II period.
Why is that? Because inflation, which was minimal before the war, rose sharply over the next 50 years.
An investor who held T-bills, the supposedly "riskless investment," between 1946 and the century's end would have had a real pretax return of only 0.4% annually. Stocks, on the other hand, would have returned 8%. Long-tern Treasury bonds, by the way, scarcely did a better job than T-bills in keeping up with inflation.
Compounded over a working lifetime of 40 years, the spread between an 8% return and a 0.4% return is enormous--almost 19-to-1 in the purchasing power you have at the end of the period. Now think about this risk: the risk of earning too little and having to retire in penury. For young savers that's a much more consequential risk than the risk of losing money in a stock over the next year.
Back before the tech wreck occured, millions of investors had persuaded themselves that there was no risk of overpaying for a Cisco or a Yahoo because tech stocks always bounced back. Today, the same people have persuaded themselves that all equities are too risky. Both views are very wrong!
* * * * *
posted by Bob Moser at
7:15 PM
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