Risky Business?

By Mike Klein
May 10, 2005

Risk isn't easy to define. I won't skydive, even if the data says my parachute will open every time. The downside is just not OK with me. But other people do it all the time -- they accept the risk. Some people won't fly on airplanes, but to me the data shows it's one of the safest forms of transportation. That let me fly to Omaha for the Berkshire Hathaway annual meeting.

There is a lot made about investing risks. Much of this is to sell you investment products that make money for someone else. But there is a simple investing strategy that reduces risk and delivers market-beating results. Read on...

You can't beat the marketThe investing concepts of risk/return trade-off, diversification, and the inability to beat an efficient market all have their roots in a 1952 paper written by MIT economics graduate student Harry Markowitz titled "Portfolio Construction." Markowitz set forth the relationship between returns and volatility, concluding that investors must subject their portfolios to higher volatility in order to earn higher returns. He also found that strategic diversification -- based on reducing correlation between investments -- reduces a portfolio's volatility but also cuts into gains. Markowitz won a Nobel Prize for his work.

His ideas have taken hold in the financial world, far beyond what Markowitz ever dreamed. You can see those ideas at work when the Wall Street elite talk about asset allocation, risk tolerance, and efficient markets. Your local financial planner will probably tell you that owning individual stocks is risky and that you should invest in index funds and diversify still further with bonds and cash. Furthermore, you will hear that in the long run, you cannot beat the market.

Return without the risk?Markowitz may have won a Nobel Prize, but Warren Buffett has beaten the market soundly for 50 years running. The handful of other investors who use Buffett's basic principles have market-beating records of 20, 30, or more years. What's more, Buffett and those who follow his principles have achieved their gains without subjecting themselves to enormous risk. How can this be? Are these accidents, freaks of probability, or luck?

None of the above. These extraordinary investors have told us for decades how they achieve their results. Charlie Munger, Berkshire Hathaway's vice chairman and Buffett's business partner, didn't mince words last year: "Diversified portfolios are madness! It's taught in all the business schools, and it's wrong." Excuse Charlie for being blunt, but he sure gets his point across, and he's right.

What's the secret?How can an individual investor achieve great returns while cutting risk? Let's detour for a moment to understand why investment firms sell diversification. They need to make a consistent profit to keep their own shareholders happy. In the 1970s, seeing the opportunity to sell a broad range of products under the guise of diversification, brokerages latched onto Markowitz's ideas and commercialized them.

Investment houses sell investing as a science -- follow our formula and you'll do fine, they say. They collect 1% or 2% a year to let you use their science, whether or not your investments perform well. And the more you trade -- in accord with their science -- the more they make in commissions. This approach achieved two things for these firms: they got more money to manage and they tapped a consistent source for revenue and profits. Unfortunately, this approach prevents people like you and me from getting the best possible return on our money.

Volatility is your friend!The most important difference between Buffett, Munger, and other value investors and Markowitz's followers is their definition of risk. In most of the financial community, stocks that go up and down a lot are considered "risky." Cisco (Nasdaq: CSCO), JDS Uniphase (Nasdaq: JDSU), and all manner of troubled companies are examples. Wall Street trades these stocks under the assumption that you have to ride the wave of these volatile stocks to get great returns -- all the while ignoring whether these companies are financially sound.

Conversely, Buffett and other value investors buy stock in high-quality companies when they are selling for less than they are worth. Value investors wait patiently for volatility to bring the stock price down well below its true value, then they buy it. In other words, they use volatility to their advantage. With this strategy, volatility can be used to lower risk! That's completely opposite conventional wisdom.

So where's the risk? There has to be some -- but when you buy shares for less than they're worth, there isn't as much of it. The stock could fall more, but it's much more likely to go up. The risk is even further reduced by considering only high-quality companies. Buffett loves it when the markets slide because it lets him find great companies selling at discount prices. That is value investing in a nutshell, and it works.

Diversification? Or diworsification?According to Markowitz, diversification reduces risk. But Markowitz looked only at volatility. He didn't examine buying stocks at a discount or the quality of a company. By using the principles of value investing, we reduce risk by buying low and considering only good companies. That changes the assumptions underlying the trade-off between risk and reward and reduces the need for the products investment firms try to sell.

Some diversification is still important to ensure that if something very unusual happens to one or two stocks, your portfolio isn't wiped out. But instead of needing to own a broad index fund, or hundreds of stocks, you can diversify with 10 to 20 well-picked stocks. For starters, a free trial to Motley Fool Inside Value will provide a list of attractive investments, along with intelligent analysis and commentary on the active Inside Value discussion boards.

Find attractive value stocksFrequently, stock prices are pushed down by the overreactions of short-term investors. Look no further than pharmaceutical giants Merck (NYSE: MRK) and Inside Value pick Pfizer (NYSE: PFE) for evidence. While they have had real problems recently, investors have overreacted and the stocks are good buys today for long-term owners. The stock of soft-drink behemoth and Inside Value recommendation Coca-Cola (NYSE: KO), with brand-name strength and a global distribution network second to none, is also selling at unusually low prices. Although we have yet to hear the second shoe drop, AIG (NYSE: AIG) is a fundamentally solid business whose stock price has been punished by short-term events.

Motorcycle maker Harley-Davidson (NYSE: HDI) is another potential example: a great brand with growing revenues, excellent profitability, a strong balance sheet, and a unique product.

Harley's stock was knocked down about 20% a couple of weeks ago because of a reduced earnings forecast.The hardest part of value investing is figuring out what a stock such as AIG is worth. This is where Inside Value comes to the rescue. Every month, Philip Durell recommends two stocks that have passed his rigorous value screening and analysis based on business fundamentals. His past picks range across industries and provide the only diversification a portfolio needs: 20 high-gain, low-risk companies.