Measuring Risk

Risk- ATG

I’ve always been puzzled by the notion of “measuring risk” when it comes to investing in the market.  If one were to ask a seasoned finance professional how risk was measured for a particular stock or portfolio, they would likely rely on a concept called Beta, which is simply the overall historical volatility (up or down) of a given stock or portfolio as compared with the overall market.  The higher the historical volatility or Beta, the riskier the stock according to this widely accepted methodology.

If one were to ask Joe Plumber how risk should be measured for a particular stock or portfolio, I suspect a response like “what are my chances of losing most of my beer money” might be pretty common.  It would also be much wiser than the Beta answer above. 

I’m not going to get into “margins of safety” or other value investing jargon in this post.  I would like to point out, however, that this is a classic example where common sense intuition regarding stock risk is far superior to generally accepted measures of risk in the investment community. 

Joel Greenblatt highlights this point by comparing two stocks.  Stock A has dropped from a price of $30/ share to $10/ share over the past year.  Stock B, on the other hand, has dropped from a price of $12/share to $10/ share over the past year.   From a “Beta” perspective, Stock A is now considered much riskier than Stock B due to its higher volatility. Said another way, the stock that has already lost 2/3 of its value is still considered “riskier” than Stock B, which has only fallen 20% in value over the past year.

From the example above one cannot definitively conclude that Stock A is safer than Stock B because it has fallen the most; but the inverse is also true- you can’t conclude Stock A is riskier because it simply had more volatility.  To answer that question a different set of parameters need to be considered- earnings stability, industry positioning, debt levels, competitive advantages, management team strength, etc.

What’s my point in stating what is probably obvious to all of you in the words above?  I don’t like risk, but I’m not afraid to embrace volatility.  In my mind they are two completely different concepts.   After all, volatility actually reduces the risk of option securities, whether you are betting on an upside or downside move.    

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