For thousands of years, mankind has understood that there is a tradeoff between risk and return. Yet the struggle to define the exact nature of the risk-return relationship continues. In the investment field, the Capital Asset Pricing Model (CAPM) is the best known traditional description of this relationship. Long before the CAPM came on the scene, however, analysts relied on experience and common sense to quantify risk.
An examination of the relation between return and three different measures of risk—one traditional measure, the Value Line Safety Rank, and two theoretical measures, beta and standard deviation—reveals some surprising conclusions. These suggest that theoretical asset pricing models could be improved by considering the factors that contribute to the risk measures investors have traditionally used.
Over the 12-year period 1974-85, safety rank exhibited the highest correlation with return, followed by standard deviation, with beta a distant third. This held true for both portfolios and individual stocks. For explaining individual stock returns, safety rank was three to four times more powerful than beta.
