Risk embodied in any given stock irrelevant to its price fluctuations

By DAVID MOON, Moon Capital Management
May 13, 2001

In the 1960s, a group of finance academic scholars, seeking to better define the elusive concept of risk, developed Beta, an easily calculable term describing the historic relationship between the volatility of stock compared to the overall stock market and Treasury bill yields. (The calculation also included a third term, 'error,' which is the portion of volatility not explainable by either of the other two factors.) The researchers argued that volatility was risk, particularly volatility compared to some standard benchmark. Risk was Beta. Beta was risk. Enlightened investment folk could not only describe risk, they could calculate it to three decimal places.

For the decades since, consultants and commentators worshipped at the altar of Beta. Imagine the furor Warren Buffet caused at the Berkshire Hathaway annual meeting a couple of weeks ago when he decreed Beta silly and a poor proxy for risk. Buffett devotees immediately accepted his pronouncements. Beta fans dismissed Buffett as a rich old man who had the financial luxury of ignoring volatility, and hence the risk captured by the Beta calculation.

So what is risk? Is it measurable? Or is it like pornography: difficult to define but obvious when you see it?

Risk is simply the probability of a permanent loss of capital.

Risk is like the wind; you can't see it but you can see and feel its effect. Can you measure it? No, but you can measure plenty of things that help you asses risk. P/E ratios, the predictability of operating income, the strength of a balance sheet, return on capital ' these are some of the tools that help an investor determine the risk of investment. If you put your money in a company, what is the likelihood you will get back something less than your investment amount? That is risk. And that probability is determined by the operating characteristics of the company, in conjunction with the price you pay for the company. It is completely irrelevant to the historic price volatility of the company's stock vis-'-vis the S&P 500.

I have heard people considering the purchase of a stock, but only if and after it increases in price. That not only increases your risk, it is stupid. 'Let's wait and see if the price goes up; then we'll buy some.' I want to sell my car to these people.

Last week, a CNBC commentator was talking about the changing expectations of investors. He noted that some investors have decided that (gasp) maybe stocks will not perpetually return 20 or 30 percent annually. Perhaps 11 or 12 percent is about all investors should expect. But, if investors are expecting 12 percent annual returns every year, there is another risk: unrealistic expectations. The long-term average return on stocks is about 11 percent a year. Following 18 years of unprecedented extraordinarily high returns, we have either reached a new plateau of stock returns (unlikely, in my opinion), or we must have some period of low or negative stock market returns, in order to return to the mean return of 11 percent. Investors expecting more run the risk that their plans for their capital will exceed the value of their capital when they need it.

It is stupid to define risk as volatility. A stock which has declined from 40 to 10, with no deterioration in underlying fundamentals, is actually less risky at 10 per share than it was at 40. But many theorists would call it more risky because it likely has a high Beta.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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