U.S. Markets closed

Forget What You've Heard About Stock Risk

Jack Hough

If apples suddenly started to float, physicists would want to revisit Isaac Newton's teachings. But stock market observers have documented their equivalent of flying fruit for at least four decades and aren't sure what to make of it.

A stock's return is supposed to be directly related to its risk, according to the Newtons of finance, including Nobel laureates Harry Markowitz and William Sharpe. Investors can find stocks with the potential for higher-than-average returns or greater-than-average safety, but not both, the thinking goes. They might as well own a basket of all stocks; hence, the popularity of index mutual funds. (Stock pickers like Warren Buffett disagree, of course.)

But a study published last year in "Financial Analysts Journal" showed something the theories don't predict: Over the 41 years ended in 2008, low-risk stocks outperformed high-risk ones. One interpretation of the findings is that, if risk truly predicts returns, we haven't yet come up with a way to accurately measure risk. The study used one of the most common measures, past trading volatility. Another possibility this one may require a long meditation over a stiff drink -- s that we struggle to measure risk as separate from returns because they are secretly the same thing. Both seem made from the same ingredients; a stock's valuation helps predict its return and its riskiness.

The simplest takeaway, however, is that investors shouldn't rely too heavily on mathematical risk models when it comes to keeping their money safe. The high-finance way to reduce the risk of a portfolio is to select investments with low "correlations" to each other -- n other words, while some have a history of zigging, others have zagged. But the recent financial crisis suggests that during times of stress, stocks forget their correlations and run together like scared gazelles. It's better to think about managing the risk of a portfolio by selecting companies that make money in different ways and places.

Similarly, there seems little point in shying away from "low-beta" stocks, or ones with mild past price swings, for fear that they will produce dull returns. The study suggests otherwise -- that investors can seek safety and returns. Perhaps investors go out of their way to buy sexy high-beta stocks, bidding up their prices and making the low-beta ones a better deal by comparison.

Index funds are fine investments, by the way -- especially for investors seeking cheap, broad exposure to stocks. For investors who pick their own stocks, below are some with betas below 1.0; this means they have been less volatile than the broad stock market over the past five years. Beta alone doesn't show whether a stock is safe, of course. These firms also earn healthy returns, seem modestly priced relative to their earnings and have a record of increasing their dividend payments.

More from SmartMoney: