"If someone starts talking to you about beta, zip up your pocketbook."
-- Warren Buffett, Berkshire Hathaway's 2001 annual meeting
The Oracle of Omaha thinks it's dangerous to use beta as a way to measure risk, and implicit in that quote, he thinks you may lose you money if you do. Is he right?
Beta is just a simple way to quantify a stock's volatility. Anything over 1.0 means a stock has historically exhibited higher highs and lower lows than the overall market. Conversely, a beta of less than 1.0 means a stock is less volatile than the market, while any stock around 1.0 tends to move as the market moves.
A quick screening for high-beta stocks brings up companies such as Baidu.com
Is Buffett nuts?
Looking at these companies you may be wondering just what Buffett is thinking. Of course Baidu.com, a Chinese Internet search firm, is riskier than multinational mega-conglomerate General Electric!
But here's his point: The more information and knowledge you have about a business -- the quality of management, competitive threats, efficiency of the business model, competitive advantages, etc. -- the less real risk you're taking on if you decide to buy it.
Beta, after all, has no knowledge of a company's fundamentals. It doesn't know how well the business is performing, and doesn't help you at all in uncovering truly important things like improving economies of scale, high switching costs, network effects, and other competitive advantages.
Beta is useful in letting you know what kind of ride you may be in for with a stock (price risk), but the real risk to investors is permanent loss of capital -- and the best way to combat this fundamental risk is to have intimate knowledge of every company you own. Put another way, the more of a long-term investor you are, the less useful beta becomes as a risk measure, and the more you should avoid worrying about it. If you're only investing money that's not needed for several years (always a good idea), you're far less likely to be selling when your stocks have taken their inevitable dips.
David and Tom Gardner, co-advisors of Motley Fool Stock Advisor, agree with Buffett 100%. In particular, they employ this principle in their monthly Best Buys Now list -- the five stocks from their current recommendations they believe offer the best bargains for new money. It combines some powerful factors. First, a great bunch of stocks to choose from, with the average pick up 50% vs. 1% for the S&P 500. Second, an intimate knowledge of those stocks as a result of following them for months or years. Third, they actually put volatility to good use when one of their favorite companies takes a price hit, giving them an attractive entry point.
One example of that is Activision-Blizzard, which David recommended in the September 2002 issue at a split-adjusted $3.48. Six months later, the stock was down nearly 50%. This was a volatile stock, but not risky in David's view because he knew Activision's business model and prospects thoroughly. He recommended the stock again, and those two positions are now up 260% and 600%, respectively.
If you're interested in the two new Stock Advisor recommendations this month, as well as the best five stocks to buy right now, Tom and Dave are currently offering a 30-day no obligation free trial. Here's more information.
Fool analyst Rex Moore regrets to inform you he is no longer available for birthday parties. He owns no companies mentioned in this article. Baidu and First Solar are Motley Fool Rule Breakers selections. Apple is a Motley Fool Stock Advisor recommendation. This information is brought to you by the Fool's disclosure policy.