Does the Market Offer Any Safe Stocks?

Physician's Money Digest, September15 2003, Volume 10, Issue 17

Many investors, worried about taking significantlosses, try to invest solely in"safe stocks," even if this means theyearn a lower return than with aggressivestocks. When they say this to their brokers or financialadvisors, they're advised to invest in utility sector,high-dividend, and large cap stocks, which aresupposedly safe stocks. These advisors may be honest,but from the clients' point of view, this is misleadingstock advice.

What the investors are looking for are stocks thatmay not do as well as the market in good times, butthat lose little or no money when the market goesdown. Such safe stocks don't exist. There are saferstocks, but no safe stocks.

Safe vs Safer

Beta calculations

In finance, the most commonly used measure ofrisk, and hence safety, is a stock's beta. The beta is ameasure of how risky a stock is relative to the overallstock market (ie, the S&P 500 or the Wilshire5000). : A stock with a beta of 1 isas risky as the market, which means that if the marketgoes down 20%, the stock is likely to go down20% as well. A stock with a beta of 0.5 is half asrisky as the market, so if the market goes down20%, the stock is likely to go down 10%.

So if you're looking for an impregnably safestock, you're looking for a stock with a beta of 0 orclose to that. No one has ever seen such a stock.In fact, they don't exist.

The lowest beta is around 0.5. You can find agood number of stocks that have betas in the rangeof 0.5 to 0.8. When your broker or financial advisortells you a particular stock is a safe stock, if they'reknowledgeable, what they mean is that it's a low-betastock (ie, in the 0.5 to 0.8 range). It's not safe,per se, but it's safer, and if the market goes down30%, the stock will still lose 15% to 24% of itsvalue. Its dividend, size, big name, etc, don't provideimmunity from the ravages of bear markets. If youhave any doubts, look at GE, IBM, or any otherstocks that market mavens once thought were safe.

Selecting Your Risk

At this point you may be pondering 2 questions:How do I find low-beta stocks, even if they're safer, notsafe; and is there truly no chance of my holding a reallylow-risk portfolio with stocks carrying a beta of 0.2?

You're in luck on both counts. You don't have togo looking for low-beta stocks, and you can actuallycreate a portfolio of almost as low a beta as you want.There are 2 keys. First, investments like money marketfunds and short-term bonds have very low betas—close to zero, if not exactly zero—whereas an S&P500 or Wilshire 5000 fund has a beta of about 1.Second, the beta you should care about is the beta ofyour portfolio (ie, the weighted average of the betas ofeach holding) and not of its individual holdings.

What this means is that if you put 20% of yourmoney in an S&P 500 fund and the other 80% in ashort-term bond fund, the beta of the portfolio willbe about 0.2 (20% x 1 + 80% x 0). You can create aportfolio of whatever beta and safety you want bymixing these 2 ingredients in the right proportion.No need to search for low-beta stocks or seek divinewisdom from TV's talking heads.

Unfortunately, as you may have already figuredout, there's no free lunch here. The safer you want tobe and the lower a beta you aim for, the more moneyyou will put in the short-term bond fund, and thelower the portfolio's expected return will be.

Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2002),currently teaches finance at the FordhamUniversity Graduate School of Business and consultswith individuals on financial planning andinvestment management. He welcomes questionsor comments at chandansen@aol.com.