Portfolio manager Cale Smith’s riffs on investing, spoke funds, and Islamorada in the Florida Keys.

My column in today’s Keys Weekly.

Q. How should I think about risk when investing in stocks?

A. Risk is a highly theoretical, strongly debated topic when it comes to investing. I wrote a partially tongue-in-cheek answer to this question last fall, but I’ll try again without the lame humor.

When it comes to investing in stocks, Wall Street and academia have traditionally described risk using a metric called “beta,” which quantifies the movements of a stock’s price compared to both the market as well as the price of other stocks. The general rule of thumb is that a beta greater than 1.0 means the stock will fluctuate up and down more than the broader stock market, while a beta lower than that threshold means it will fluctuate less – or even in the opposite direction. By this logic, high beta stocks are riskier, and low beta stocks are safer.

Here is the problem with that approach, however. It measures the fluctuation of stock prices, not business value. Rational investors should not be concerned with stock price changes – except when you can take advantage of them. The only thing that really should matter is how the stock price compares to the long-term value of the business.

Relying on beta can fly in the face of common sense. For instance, Google shares had a higher beta at $260 per share at the end of 2008 then at $700 per share at the end of 2007. Now, I ask you…when was the riskier time to buy?

To value investors, beta is useful only when it confirms something you probably already know – that the stock price is volatile because the company’s long-term prospects are, too. Otherwise, I think it’s better to think of risk in common-sense terms. Specifically, what are the odds that you’re going to lose all of your money, or see a permanent decline in your investment?

You should attempt to minimize that kind of risk every way possible – starting with sticking to companies with clear and consistent future prospects. But you’ll miss some great investment opportunities if you confuse volatility in stock prices with real risk.

Q. How many stocks should I own?

A. I’d like to clarify two points for new readers. The first is that I believe that the majority of long-term investors are best served by investing in an index fund – a widely diversified, passively managed fund built just to match the performance of the whole stock market.

The second point is that if you’re going to build a focused portfolio containing a limited number of stocks, you either have to really know what you’re doing or find someone that does. One of my favorite quotes sums this up well: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

My own beliefs about diversification are the opposite of conventional Wall Street wisdom. In short, while diversification can play an important role in protecting overall wealth, I believe it is of limited use when you are trying to really grow a specific portion of your assets. It is simply a mathematical fact that the more stocks you own in your portfolio, the lower the odds are that you’ll be able to outperform an index fund.

In addition, putting your money to work in your best ideas also just makes more intuitive sense to me. If you own four stocks and one increases by 50% while the rest stay flat, your total portfolio will gain 12.5%. If you own 100 stocks and one increases by 100%, your portfolio is only up 1%. Why put money in your 76th best idea?

I believe you can reduce risk by deeply understanding the companies you invest in, as well as knowing their real value, not by spreading the risk across more companies. I see danger in owning too many investments because it becomes too hard to closely follow the progress of too many businesses.

So you probably don’t need to know more than a dozen companies really well over the course of your life to become wealthy. But you do have to know them very well.

Q. Why do you say value investing is the best way to pick stocks?

A. I believe value investing is the only rational way to invest. Some analytical ability is required, but investing intelligently is not nearly as difficult as Wall Street would like you to believe.

There’s a central concept behind value investing that people seem to get immediately or it eludes them forever. The concept is that a publicly-traded company has two values – its actual or ‘intrinsic’ value, and the value the stock market assigns to it.

Intrinsic value changes infrequently, while stock market value can change every few seconds. By determining the intrinsic value of a company, and comparing it to the stock market’s assessment, we can buy small pieces of the best businesses which are the most underappreciated.

Purchasing shares only at prices far less than what they are truly worth is critical for two reasons. First, it protects you from permanent loss. This “margin of safety” concept is unique to value investing.

Second, buying well below intrinsic value presents the potential for substantial appreciation once the market recognizes the company’s true long-term value. And it rarely fails to do so.

Where is the proof that value investing works? In at least two places.

First is at the very top of the list of the world’s richest people. There you’ll find Warren Buffett, the most famous practitioner of value investing.

There is a simple math proof, too.

Say Corley buys shares in a company for 50% of their intrinsic value. The intrinsic value of the company then grows 12% per year by doing nothing more than retaining its own earnings. Even if it takes four years for the market price to reflect the company’s true worth, her investment will still have compounded at 30% per year.

Mathematically, two thirds of that return comes from the gap between market price and intrinsic value closing. Only one third comes from the business value growing. So growth is essential when looking for companies to invest in, but it’s less important than buying shares at a low price.