Deviant Behavior and Beta

As promised from last week, now it's time to analyze risk and put some numbers to risk.

We've already discovered the difference between market risk and diversifiable risk, so how do we eliminate risk and what kind of risk can we focus on eliminating?

Well, we cannot eliminate market risk, so we are only left with the possibility of eliminating diversifiable risk. And being a finance geek, I like numbers to help me choose which project is the least risky. Let's look at an example first.

Assume that since you're my friend, I left you $100,000 to invest anyway you see fit and you're left with two possible choices. Choice "A" is to invest in a little stock we'll call "GE." GE has been around 100 years and is very steady and consistent, although not very sexy or glamorous when it comes to a crazy return. You can expect to earn 9% per year from GE.

Choice "B" is a little-known company called "Ola's Tapioca Mine and Tattoo Parlor." The main office is located in Key West, FL and they hope to franchise the concept throughout the country. They, too, expect to give you an 9% return on your investment next year.

So where do you invest and why?

Unless you have a real strong, strange urge for a new tattoo and some tapioca pudding, you will most certainly put your money into GE since there is far less risk and the return is exactly the same as a risky proposition. This is an investors natural reaction to avoid risk and maximize returns and the only way you'd consider "Ola's Tapioca Mine..." is if they had an expected rate of return greater than 9%.

But remember, greater return comes with greater risk. Let's call this risk "BETA."

Now let's also assume that the stock market has a BETA of 1.00, and we know that the average return in the stock market is about 9%. We need a number to show how much more, or less, risk is associated with our investment.

GE is old and consistent. When I hit YAHOO Finance and checked out their key statistics, their BETA was .75. This means that for every 1% the stock market moves up or down, GE will move 75% of the distance. So, if we expect the stock market to go up 10% next year, we would expect GE to go up 7.5% next year. Similarly, if we expect the stock market to go DOWN 10% next year, we'd expect GE to go down only 7.5%. So while our expected rate of return is the same as the stock market, our risk is actually 25% LESS. Hmmm..

Our Tapioca Mine might have a BETA of 1.5. This means that if the stock market went up 10%, we'd expect the Tapioca Mine to go up 15%, and vice versa if the market went down. In essence, our investment is 1.5 times riskier than the stock market and offers only a similar return. Not good.

There is a different figure we can use as well that capitalizes upon standard deviation, but that's not necessarily a blog type of entry. I just want you to be comfortable when you see the term BETA Coefficient going forward and recognize what it means.

Also recognize that BETA is utilized to compare projects that you are considering as a business, along with standard deviation and coefficient variation. If you'd like help with any project analysis, including PERT charts, please let me know as I have experience in these things and would be delighted to assist you.

Finally, recognize that you can get most of these figures for free from YAHOO Finance, CNNFN, etc. Research doesn't have to be expensive or time consuming.

Former Magellan Fund Manager and investing legend Peter Lynch often said his best source of research was his wife and his teenage daughters. They knew retail trends and hot fashion better than a 50-year old investment fund manager, so he learned to trust their judgment on what was hot and what was not. He simply put pen to paper to see if the numbers made sense, which they often did.

Use your common sense when looking at investment choices. Many times, you know something the pros don't or something they miss in their analysis; something you can use to make a lot (or save a lot) of money.

Next up: Positive and Negative Coorelation (not much of a teaser, but certainly a reminder to me of what the heck to write next week.)

Visit our sponsors and help me keep the lights on! Click the links above and please send me a comment or two. It gets lonely out here in cyberspace.