Mutual fund managers largely measure risk with a one-size-fits-all metric called beta. Unfortunately for fund investors, beta is nothing more than a measure of a stock's or fund's price moves in comparison with the market. While that's important to folks whose jobs and bonuses depend on how closely they track their respective indexes, it carries precious little meaning to real-world investors.
For those of us who care more about seeing our money perform well on an absolute basis, rather than simply on a relative basis, there are far more important risks to consider. After all, what's the point of investing if the market lost 50% of its worth and you beat it by losing only 25%? In the real world, valuation risk, competitive risk, and operating risk are three very real risks that matter far more than the largely useless beta.
And the only chance you have of protecting yourself from those risks is by learning how to recognize them before they catch you by surprise.
You still can lose money
While daily stock price fluctuations mean very little for a business owner, you still are not guaranteed to make money in your investments. Fortunately, though, with your attention focused in the proper location, you improve your chances of doing well. That's because you'll be paying attention to what really counts -- the business itself. And doing so will enable you to make much more rational decisions with your money.
Take, for instance, Cisco Systems (NASDAQ:CSCO). Throughout the 1990s, Cisco grew at a phenomenal rate, thanks to the buildout of the Internet and the demand for companies to upgrade their networks to make them Y2K-compliant. Had you followed the Wall Street model of risk, you would have noticed that Cisco's shares moved more than most, but since its general direction was up, you wouldn't have minded.
Had you paid attention to the business behind the stock, though, you should have noticed in 1999 that its share price had lost its connection with the business' delivered financials. To justify its stock price at the time, you would have had to predict impossibly high, perpetual growth. No volatility-focused risk model would have told you that Cisco would today trade at below a quarter of its peak levels, some six years later. A model that looked at the business behind the stock, however, could have easily helped you find the valuation risk inherent in Cisco at the time and step away.
Castles and moats
In addition to making sure you avoid clearly overpriced companies, you need to understand that most companies face tough competitive pressures. Competitive risk is a real risk that companies and their investors face. There's nothing that brings other companies running in to spoil a party quite as quickly as profits. Consider the case of Fair Isaac (NYSE:FIC). As the company behind the famous FICO credit scoring system, it had a virtual stranglehold on figuring out the likelihood that any given individual would default on a loan.
Being a key part of virtually every major credit decision is a pretty strong strategic barrier to competition. Or at least it was, before Fair Isaac's major customers, Equifax (NYSE:EFX), Experian, and TransUnion, decided to create a product called VantageScore to directly compete. With its moat breached, what had previously seemed to be a decent price for Fair Isaac no longer appeared reasonable.
As Fair Isaac shows, even if a company looks fairly priced, its true value can suffer if its competitive position weakens unexpectedly. With that in mind, ask yourself what looks like a fair price for search titan Google (NASDAQ:GOOG), if its archrivals can finally create a competitive product with staying power. In all likelihood, it's nowhere near the $115 billion market cap the company has today.
Stuff happens
Unfortunately, problems don't come only from the outside world. Sometimes, a company's own operations can cause it grief. Merck's (NYSE:MRK) arthritis drug Vioxx and Pfizer's (NYSE:PFE) related compound Bextra did considerable damage to the reputations and share prices of their respective companies. As it turns out, those wonder drugs weren't so wonderful; they may be associated with increased risk of heart attack or stroke.
What had been two exceptionally strong companies trading at decent valuations went overnight into a virtual stock market freefall. With those products withdrawn from the market, significant anticipated revenues simply vanished. And with the likely liability from the apparent health risks, the companies faced skyrocketing costs. In the case of these pharmaceutical giants, it wasn't valuation or competition but rather their own operations that caused them trouble. They simply turned out to be riskier than anyone had anticipated.
Buy quality cheaply
At Motley Fool Inside Value, we take real risk seriously. Our goal is to beat the market by ignoring the day-to-day movements in stock prices and focusing instead on finding high-quality businesses trading well below their true worth. We pay attention to what really counts -- valuation, competition, and operations. With that dedicated focus, we find and buy companies that have been unfairly discarded among the legions of fund giants more focused on price movements than on business quality.
As our market-beating results show, your returns can improve when you ignore the hype and hysteria of volatility and invest based on a solid business behind the stock. Join us at Inside Value. Today's a particularly good day to start a free trial -- our two-year review issue releases at 4 p.m. EDT. Start paying attention to the risks that really count.
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At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Fair Isaac and Merck . Pfizer is an Inside Value selection. Merck is a former Income Investor recommendation. The Fool has adisclosure policy.
