Make Money With Risk

There are so many ways to look at risk. I've discussed before, for example, how risk and return are related. Typically, you need to take on more risk to make more money. Low-risk investments, such as government bonds or CDs, tend to offer relatively low growth (though at some times, such as when interest rates are high, this isn't true). Add some riskiness, as with stocks, and you tend to earn more. And then there's the lottery -- huge payout, but huge risk. The risk is so huge that it's much more likely that you'll lose your entire "investment" than win the lottery.

I recently read a wonderful perspective on risk in an essay I received from one of the mutual funds I own, the Muhlenkamp Fund (MUHLX). It's a Motley Fool Champion Funds newsletter recommendation, and it not only delivers good performance but also sends out regular, educational material. Here's a recent snippet:

We believe most people define risk as the possibility of losing money. We define risk as the probability of losing purchasing power (i.e., money adjusted for inflation). But Wall Street has come to define risk as the volatility in price. By Wall Street's definition, those securities whose prices move the most (up or down) in a short period of time are considered the "riskiest." Those whose prices don't move, like certificates of deposit, are the "safest." We reject this definition of risk. We call price volatility "volatility."

Touche.

On beta
The Wall Street view of risk as volatility is reflected in "beta," a measure reflecting how volatile a security is in relation to the overall market. So if the market goes up 10% and Home Surgery Kits (ticker: OUCHH) goes up 20%, its beta is 2.0. If it goes up just as much as the market, its beta is 1.0. If it goes down 5%, its beta is -0.50.

If you decide to avoid stocks with high betas in order to reduce your risk exposure by this definition, what kinds of firms will you be rejecting? Here are some companies with high betas:

Does this list look like anything from Night of the Living Dead? Did you break into a cold sweat reading it? I thought not. Sure, some high-beta companies, such Sun Microsystems, have been struggling. But in Sun's case, its high beta seems to stem from the company's having nearly doubled its stock price over the past year. Meanwhile, eBay is a healthy, growing company trading at a not-astronomic price, according to many savvy sorts. In our CAPS stock-rating system, 416 of our best players predict good things for the company, versus only 30 predicting underperformance.

Now let's look at some low-beta companies:

These might seem more attractive because they're less volatile than the overall market, but they're not necessarily the best bets out there.

The bottom line for me, and perhaps for you as well, is that beta is rather irrelevant. Companies with low betas will sometimes implode, while companies with high betas can be wonderful long-term performers. Indeed -- a high beta indicates significant price volatility, which can be good if you're looking for an attractive entry point into a stock. If it's very volatile, you stand a decent chance of seeing the stock price slip temporarily, long enough for you to snap up some shares. So don't write any company off because of its supposed high "risk" suggested by a high beta.

Back to risk ... and value
Now that we've dispensed with Wall Street's idea of risk, how should we really think about it? Well, I like the Muhlenkamp perspective -- that riskiness should relate to how likely you are to lose purchasing power on an investment. In other words, when buying a stock, you should be asking yourself how confident you are that it will perform well enough for you to get a market-beating performance, including beating inflation.

One way to lower your risk in this regard is to be a "value" investor, seeking investments that seem to be priced at considerably less than their intrinsic value. This gives you a built-in margin of safety. Many of the world's most respected investors -- such as Peter Lynch, Philip Fisher, John Neff, and Benjamin Graham -- are firmly in the value camp.

Our Motley Fool Inside Value newsletter is also in the value camp. It's headed by Philip Durell, who focuses on ferreting out undervalued companies, and his record of beating the market with average returns of 24% vs. 17% is promising. (Indeed, in less than three years, he already has 13 recommendations up more than 50%.) He explains his perspective a bit here:

A good working definition of a value stock is one that can be bought for a price that offers a big enough margin of safety that if you are wrong in your analysis or if there are fundamental shifts in company's strategy, you are protected from losing much money. Our goal is to achieve excellent returns while minimizing risk (i.e., the downside).

I invite you to take advantage of a free trial of Inside Value for 30 days (with no obligation). During that time, you'll have full access to all past issues and all recommendations. In the meantime, get more perspectives on risk and beta in these articles:

• Beta: The Alpha and Omega to Risk Analysis?
• It's All Greek to Me
• Invest Well, Sleep Well

Longtime contributor Selena Maranjian owns shares of eBay, which is a Motley Fool Stock Advisor pick. The Motley Fool is Fools writing for Fools.