B. Risk (continued)
Why is a low risk (less volatile) stock better than a high beta stock. The following example demonstrates why. Assume two investors each have $100,000 and each average 15% return over a five year time horizon. Investor A has a low beta stock while investor B has a high beta stock. Assume at the end of three years both have averaged 15% so the value of their portfolio would be $152,000. However in the fourth year assume that investor B’s stock goes down by 15% while investor A’s goes up 15%. At the end of the fourth year investor A’s portfolio would be worth $175,000, while investor B’s would be worth approximately $129,000. Now in order for investor B’s total returns over the 5 year period to average 15%, he would have to have a return of 56% in the last year to get all the way back to the value of investor A’s portfolio which is now worth $201,000. The “steady eddie” stock has a tendency to do better for you in the long run. We will soon see how to identify the “steady eddie’s” in the stock market.