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.
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.
They aren’t especially effective, however. Here are some impressive-sounding terms investors can ignore, along with simpler ways to stay safe.
Beta: 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. For example, U.S. Bancorp USB, +0.52% has a beta of about 1, meaning it has been as volatile as the market, while General Electric GE, -0.12% at 1.6, has been more volatile and Pfizer PFE, +0.03% 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 professor 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, +0.24% for example, has a beta of 1.2 but prospered straight through the global financial crisis. Netflix NFLX, +0.51% 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.)
Correlation: 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 SectorSPDR.com.
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, +0.28% and some that sell things they merely covet, like handbag maker Coach COH, +0.14% Mix fast growers like Google GOOG, +0.42% with stalwart dividend payers, like Abbott Laboratories ABT, -0.26% Avoid holding too many companies that collect the bulk of their income from the same source. Health insurer Humana HUM, +0.86% and communications specialist Motorola Solutions MSI, +0.05% are dissimilar businesses with the same key customer: the U.S. government.
Hedging: This term can refer to a variety of ways to protect against stock declines. One common hedging method involves using options contracts to bet against individual stocks or the broad market. In a crash, the stocks lose money but the options can offset those losses. It’s like insurance.
The problem: When a homeowner buys property insurance he gets full protection that costs, in many cases, less than 1% of his house value per year. For an individual stock investor to buy that level of protection could cost more than 5% a year — enough to more than erase the S&P 500’s gain from the past five years. He could buy a short-term hedge, but someone who knows just when stocks will tank doesn’t need hedging.
Some safeguards are free, however, like the combination of time and cash. If the stock market slides next week, companies will continue to produce profits and even pay dividends. Those dividend payments will gradually offset price declines, and investors who reinvest them into more shares will benefit doubly from the eventual recovery in share prices.
To wait out a downturn, investors must be able to pay their living expenses. Cash and bond income will help with that. Conservative investors should have easily accessible savings that will pay the bills for six months, along with 40% or more of their portfolio in bonds.
Of course, some investors can’t afford a five- or 10-year downturn in the stock market, no matter their allocation to cash and bonds. They should avoid stocks.
Defensive investing: “Defensive” investing refers to buying securities and assets that tend to hold up well during times of financial stress. For example, if a recession strikes, Caterpillar CAT, +0.39% whose equipment sales depend on demand for new construction, might fare less well than General Mills GIS, +0.36% whose cereal sales depend on demand for breakfast.
But stock returns depend largely on the price investors pay, and defensive companies can get expensive during periods of high investor anxiety. General Mills now costs 60% more than Caterpillar relative to trailing earnings.
Truly defensive investing involves checking the valuation, not just the sector. Fast-growing companies are sometimes worth premium prices. But at the moment, the priciest S&P sectors relative to next year’s projected earnings are steady, slow-growth ones: consumer staples, telecom and utilities.
That is a sign that truly defensive investors should look beyond traditionally defensive stocks.