Judge with logic how risky stock market is at today's investment level

By DAVID MOON, Moon Capital Management
January 20, 2002

A recent Wall Street Journal/NBC News poll asked investors to rate 'the risk of losing money in the stock market today compared to a year ago.' Fifteen percent of the respondents rated the current market 'somewhat' or 'much less' risky than a year ago. About a third rated the risk of losing money today about the same as a year ago. Over half of the investors described the risk of losing money as 'much' or 'somewhat' riskier than a year ago. As is too often the case, investor emotion is more prevalent than logic.

Assume for a minute that the S&P 500 is 'the stock market.' (Fortunately, it isn't, by a long shot. But that's another topic.) If the S&P 500 is the stock market, what do we know the probability of the stock market losing money was in 2001? Since we have the benefit of perfect hindsight, we know that there is a 100 percent chance the S&P 500 will decline (did decline, actually) in 2001. So is the S&P 500 more or less likely to decline in 2002, compared to a year ago? It is impossible for the odds to be greater than 100 percent this year. And it is highly unlikely that anyone, even the most pessimistic of investors - considers the odds of losing money in 2002 to be 100 percent. Therefore, the risk of losing money in the S&P 500 must be less in 2002 than we now know the risks were in 2001.

Part of the problem with 'the riskiness question' is that too few people have a clear understanding of risk. Everyone has a definition, but few of those definitions are clear. And even fewer are useful.

My college professors taught me that risk was volatility. (Or that risk could be measured by volatility. Or something like that; it's been a few years.) Using volatility as a measure of risk is convenient because there are all sorts of ways to calculate volatility to the 14th decimal place.

But if you've owned Mattel stock for the last four years, what difference does it make to you if its beta (or any other volatility measure) is 0.38 if the stock price has fallen from 44 to 18?

Let me offer an alternate definition of risk: the probability of a loss of capital. If you buy a stock and sell it five years later at a loss, that seems a bit riskier than a stock bought and sold on those same two days at a profit. One of the problems with this 'definition' of risk, however, is that it isn't measurable.

Another way to consider risk is to estimate your worst possible outcome and try to predict the probability of that outcome. If you put \$10,000 in Amazon.com in December 1999, your investment would currently be worth about \$860. It seems to me that the stock is less risky now than it was two years ago. It is cheaper. It may still be a poor investment, but is closer to whatever its bottom price will eventually be. Compared to Amazon.com at \$113 a share, the stock is less risky at \$9.75.

Assume for a minute you are considering buying a 1954 Chevrolet pickup truck. You are concerned that you may be overpaying for the truck at the current asking price, \$2,500. You aren't sure if you can resell the truck at a profit or not. If the owner then drops the price to \$1,000, is the purchase of the truck more or less risky? It is less risky, of course. The purchase may still be extremely risky, but it is much less risky than when the price was 150 percent higher.

That is our stock market. The S&P 500 is much less risky than it was a year or two ago. (Although it may be less risky still a year from now.) But you can buy companies today at prices that are 30 or 40 percent lower than a year ago. That equates to a less risky market ' not more so.

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