Assessing Risk the Right Way

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We humans just mess everything up, don't we? We put out the trash on the wrong night. We go through half our lives thinking that segue is pronounced seeg. We drive across town to save $50 on a TV set, but then put off contributing to a Roth IRA for a few years and lose out on tens of thousands of retirement dollars.

Here's one more example: We often look at risk incorrectly. I read recently in The New York Times about an upcoming report in the Journal of Consumer Research which found investors reacting irrationally to a stock's "run length." Investors were shown two stocks that offered the same monthly and annual returns, but one stock rose one day and fell the next, while the other rose steadily every day during the first half of each month and then gave its gains back by the end of the month. So the only difference was how long each would rise before falling, and vice versa. Yet investors perceived the stock with the shorter run length (the former) as safer -- when it wasn't.

We often behave similarly with beta -- the term for a stock's volatility that reflects how much it moves in relation to the overall market. So a stock that tends to gain 10% when the market does would have a 1.0 beta, while a stock that tends to gain 15% when the market gains 10% would have a 1.5 beta. Investors sometimes think that a low beta is good, but really, if you're buying a stock and aiming to hold on for years, how much does it really matter whether its graph features deep and high spikes, or small zigzags?

What really matters is simply how it grows: where the graph begins and ends, what you pay for the stock and what you get for it when you sell.

For instance, notice how the betas on these stocks don't really match up with their long-term returns:

Company	Beta*	10-Year Avg. Annual Return
Terex (NYSE: TEX)	2.69	6%
Caterpillar (NYSE: CAT)	1.87	11%
Rio Tinto (NYSE: RTP)	1.51	15%
Corning (NYSE: GLW)	1.27	(3%)
3M (NYSE: MMM)	0.76	8%
Activision Blizzard (Nasdaq: ATVI)	0.64	26%
Wal-Mart (NYSE: WMT)	0.21	1%
Apollo Group	(0.11)	21%
S&P 500		0%

Data: Yahoo! Finance and Google Finance.
*Beta values use data from past five years.

Clearly, a high beta shouldn't be a dealbreaker, just as a low one is no guarantee of great returns. Focus on a company's health, competitive advantages, growth prospects, and value. The risk is in its fundamental characteristics, not how its stock price moves.

To find the best growth stocks, you have to look beyond the most popular companies. Jordan DiPietro has one stock recommendation you should buy before your neighbor does.