10/4/2012 8:03 PM ET|
4 financial terms it's safe to ignore
Wall Street has some impressive-sounding concepts meant to help investors identify risks and stay safe. Trouble is, they're not particularly effective.
Stock investors are said to be motivated by fear and greed, but after the recent rally it might feel more like fear and fear.
There is the age-old fear that share prices could fall tomorrow. Then there is the more modern fear that the Federal Reserve will hold interest rates so low for so long that owning bonds and savings accounts, after subtracting for inflation, will do more harm to a portfolio than a stock decline would.
For the deeply nervous, Wall Street has a medicine chest filled with measures and terms meant to soothe. They are said to identify risky stocks, tell which ones work well together and help safeguard against declines.
Trouble is, they aren't especially effective. Here are some impressive-sounding terms investors can ignore, along with simpler ways to stay safe.
Imagine a number that quantifies stock risk. "Risky" stocks would offer greater potential returns but also increased likelihood of losses. Nervous investors would gladly settle for moderate returns with low-risk stocks.
Some investors think of "beta" as such a number. It describes how volatile a stock (or other asset) has been relative to a benchmark, like the Standard & Poor's 500 Index ($INX). For example, U.S. Bancorp (USB) has a beta of about 1, meaning it has been as volatile as the market, while General Electric (GE), at 1.6, has been more volatile and Pfizer (PFE), at 0.7, less volatile.
As a risk measure, however, beta has flaws. It is backward-looking, so it doesn't account for how companies have recently changed. It can't measure the chance of future pitfalls, so it isn't truly a risk measure. Also, according to a 2011 study by Harvard Profesor Malcolm Baker and others, low-beta stocks have done better over the long haul -- something that isn't supposed to happen.
A better approach to spotting safe stocks is to study financial statements. Companies with modest debt and improving profits that don't vanish during periods of economic stress can be good bets. Apple (AAPL), for example, has a beta of 1.2 but prospered straight through the global financial crisis. Netflix (NFLX) has a beta of 0.7 but is expected to barely turn a profit this year.
Keep in mind that even rock-solid profits don't make an overpriced stock safe. (More on that later.)
Similar to beta, "correlation" is a statistical measure of how two assets have traded relative to each other. It ranges from 1 (perfect lock step) to minus-1 (perfect opposites). Investors can find stock correlations using online tools like the one at Select Sector SPDRs.
Find stocks that are only loosely correlated with each other, the thinking goes, and some will continue to do well even if others tumble.
But correlation is like a car's air bag that works except during collisions. During the market meltdown of 2008 and 2009, risky assets fell in unison, regardless of how they had behaved in earlier years.
As with beta, a better way to buy stocks that complement each other is to forget share-price movements and look for companies that make money in diverse ways.
That means holding some companies that sell things customers need, like power company Consolidated Edison (ED), and some that sell things they merely covet, like handbag maker Coach (COH) . Mix fast-growers like Google (GOOG) with stalwart dividend-payers, like Abbott Laboratories (ABT). Avoid holding too many companies that collect the bulk of their income from the same source. Health insurer Humana (HUM) and communications specialist Motorola Solutions (MSI) are dissimilar businesses with the same key customer: the U.S. government.
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Quote from article: "There is the age-old fear that share prices could fall tomorrow. Then there is the more modern fear that the Federal Reserve will hold interest rates so low for so long that owning bonds and savings accounts, after subtracting for inflation, will do more harm to a portfolio than a stock decline would." This is the way it is and the way it is going to be. America could not pay the interest on the national debt if interest rates went a little higher. So all you money saver in CDs, money market accounts and bonds are just going to have to get used to making near nothing. This is ridiculous but it is the way it is.
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