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Let’s assume company XYZ’s stock has a return on investment of 12% for the year and a beta of + 1.5. Our benchmark is the S&P500 which was up 10% during the period. Is this a good investment?
A beta of 1.5 implies volatility 50% greater than the benchmark; therefore the stock should have had a return of 15% to compensate for the additional volatility risk taken by owning a higher volatility investment. The stock only had a return of 12%; three percent lower than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -3 and tells us it was not a good investment even though the return was higher than the benchmark.
The Correct Approach for the Value Oriented Investor
Volatility can be a blessing or a curse. That depends on how you, the investor, react to it. If you buy when everyone else is (the price is high) and sell in a panic when everyone else is selling (the price is low) then volatility is a curse. We are all prone to emotional bias.
However if you anticipate volatility it can be a blessing. The key is to stay focused on buying investments with a margin of safety. That means being disciplined in your approach to buying and selling. If you require a margin of safety it forces you to buy at a low price and sell when the price exceeds its value.
The slogan for the Dividend Value Builder is: “Discover, Evaluate, and Compare Dividend Stocks Without Emotional Bias.” The key is “without emotional bias”. Learning how to employ a margin of safety into your investment analysis helps you eliminate the emotional bias that causes us to make catastrophic errors.
If you buy a high beta stock for more that it’s worth the risk of losing your principal is very high (even greater than if you buy a low beta stock). The time to buy any asset, but especially a high beta stock, is when the price is well below its real value. Your risk is lower and your probability of a positive return is exponentially higher.
Whether you are buying high beta stocks or dividend stocks; being patient and only buying investments whose price is less than the real value of the asset lowers your risk substantially. Real risk is losing your principal. If you have an investment that is worth $100 but only pay $75 you have a 33% ($25 / $75) margin of safety.
I trust this discussion of alpha and beta has improved your understanding of what is takes to be a more successful investor. The most important thing you can do is develop a risk management plan. Positive alpha can be achieved with proper asset allocation, diversification, choosing individual investments with strategic advantages, and most importantly employing valuation strategies including requiring a margin of safety.
This article has been republished with permission from Arbor Investment Planner.