The payoff for investing in a sure thing is lower than usual these days—a 90-day T-bill only pays 1.8%.

But the quest for better returns comes with greater uncertainty. That’s why investors have developed so many tools to take the edge off the potential surprises stocks can spring on them… from fundamentals like P/E ratios to technicals like trend lines. Not surprisingly, the academics in finance have worked on the problem, too. And boy do they have a deal for you. This one involves our new best friend, volatility. We’ve had two unusual tools for looking at volatility—Average True Range and Zigzag. Now we’ll look at the one that gets all the press and even went to college.

Suppose you had to choose one stock from several to buy, but you weren’t allowed to know anything about the companies. You aren’t allowed to ask about any of their strategies for growth or to find out whether they have enough cash flow and current assets to cover the bills. You don’t know their profit margins or even what business they are in.

Well fear not, oh lucky you. You can use the academic version of volatility to measure your risk. It’s called beta, and nothing could be more uncomplicated than this. It’s a miracle anything so understandable even got published, but it did and finance schools from coast to coast have embraced it.

Here’s the drill: If the beta is high, the stock is risky, though it could pay off well but there’s a lot of danger. If beta’s low, the stock will probably just hum along. The return may be market average or modest, but the risk is low.

So far, we’ve looked at volatility you can see with your eyes, volatility you can measure in dollars and sense (ATR). And volatility you can describe in percentage (Zigzag). The academic’s beta version is volatility measured yet another way—in comparison to the market. Usually, they use the S&P 500 as a stand-in for the market.

This measure assumes the market has a value of 1.0. Any stock that moves in tandem with the market, about the same amount also has a 1.0 beta.

If it moves twice as much, beta goes up to 2.0.

If it moves 20% less than the market, the beta falls under 1.0, to 0.8.

You get the idea. It can also be negative. If a stock moves half as much as the market, but in the opposite direction, the beta is -0.5. Most stocks fall between .5 and 2.5, with more of them clustered toward the higher end of the scale.

So now you know exactly how to find a safe stock. Yes, sir! You go buy yourself some Enron in 2000. You know it’s super safe because Enron only had a beta of 0.47.

Here’s your low beta— Enron 2000:

This is known as using damned lying statistics.So what if Enron is going to drop from $89 to 60 cents and you could have just looked at the actual facts of the business like cash flow instead of beta and avoided all that pain? As Warren Buffett has said, this is the kind of common sense that’s OK in practice, but it will never work out in theory.

Using beta-volatility as a measure of risk would lead you to a strange version of safety today as well. You might buy Warner Chilcott (beta 0.6), iParty (0.6) or Amcon Distributing (-0.5) or Education Realty Trust (0.2)—all companies with massive debt, poor growth and small to no profits. Any of those could be winners on some planet, but to call them low risk is like calling LeBron James medium-big.

Pages: 1 2

Pages: 1 2