Stop me if you’ve heard this before… Past performance is no guarantee of future results.
It’s easy to support recommendations with pretty performance charts and impressive statistical studies. But no amount of mathematical analysis or graphic artistry can get around the fact that companies, markets, and the world can change.
So as investors, we’re primed to think analytically about future returns… When looking at a stock, we should always ask what might change – for better or worse – in the future.
Ironically, though, hardly anybody – even the greatest minds in finance – think this way when it comes to risk…
As a whole, the investing world still addresses risk using mathematical formulations like beta, volatility, or standard deviation. Folks take these numbers as gospel and move on.
The problem is that these metrics assume that past performance does guarantee future results. (But nobody dares say that aloud!) And as a result, they don’t always help investors see the full story.
Let’s consider the most famous risk measurement – beta…
We won’t get into all the math today. You just need to know that beta is a measure of the volatility of a specific investment compared to the overall market. Essentially, it’s figured out by studying the correspondence between the returns on a stock and the returns on the overall market over a chosen time period.
For example, a beta of 1.3 would mean a stock has been 30% more volatile (risky) than the benchmark S&P 500 Index. On the flip side, a beta of 0.85 would mean it has been 15% less volatile.
Since beta looks at the past, we need to judge whether the future is likely to look different.
Sometimes, this is easy to do…
For example, consumer-goods giant Procter & Gamble (PG) has a beta of only 0.42 today.
We don’t know for sure that this relative stability will persist. But we do know what Procter & Gamble’s business is… The company sells low-price, everyday consumer basics.
Consumers don’t ever stop brushing their teeth, washing their laundry, and doing other household tasks… These chores remain even during recessions.
Now, folks might be forced to move to bargain brands, look for sales, or stretch a bottle of detergent over more loads. But even if the economy plunges into crisis mode, the bottom won’t likely fall out from under Procter & Gamble’s stock.
So common sense allows us to assume that this stock’s low volatility will persist in the future. That will be the case unless something happens to lead us to expect otherwise.
Other times, though, plausible answers don’t come as easily…
Consider semiconductor companies.
We’re tempted to assume that these technology-focused businesses are all volatile, high-risk stocks given the cycles in this space. But the betas in this group of stocks range from -2.68 for Meta Materials (MMAT) to 2.45 for Alpha and Omega Semiconductor (AOSL).
Joyful “quants” might celebrate MMAT by doing back flips. Its beta is negative. That means it’s inversely correlated to the broad market… Its stock typically rises when the S&P 500 falls, and vice versa.
Meanwhile, the betas for the more mundane restaurant industry are also all over the place… They range from 0.58 for McDonald’s (MCD) to 2.66 for Brinker International (EAT), the parent company of casual-dining chains Chili’s and Maggiano’s Little Italy.
In other words, Procter & Gamble – where knowing the specific business is useful – might be more the exception than the rule. In many cases, it’s not clear whether a stock’s future results are likely to mirror its past performance… So you must look beyond the beta.
And as such, analyzing risk winds up being a lot like how we assess potential future returns… We must dig for answers by doing further security analysis.
Now, we could do that simply by studying sources like value-investing legends Benjamin Graham and David Dodd… Their Security Analysis book is one of the most important financial books ever published.
Armed with the insights from Graham and Dodd, we could roll up our sleeves and get to work. Or we could just use an all-encompassing model that does the grunt work for us…
When it comes to identifying the level of risk within stocks, as well as their potential returns, the “Power Gauge” system is well-proven. It’s our 20-factor, proprietary model developed by Wall Street veteran and Chaikin Analytics founder Marc Chaikin.
We’ll continue tomorrow… I’ll show you how to use the Power Gauge to analyze risk.
Good investing,
Marc Gerstein
Editor’s note: If you can’t wait until tomorrow, you’re in luck… You can learn more about the Power Gauge immediately. Marc Chaikin recently put together a special presentation to explain everything from why he developed the system to a full demonstration of exactly how it works. Plus, just for tuning in, you’ll get a free recommendation. Get started right here.
