Every investor is concerned with risk at some level. Arguably investors in retirement are and should be concerned with risk the most. However, not every investor looks at or defines risk in the same way. In truth and fact, there is a wide gap between how various segments in the financial community define and view the complex subject risk.
For example, proponents of academic finance tend to have a very narrow view of the concept of risk. Academic finance seems to favor defining risk as volatility. Since much of their work is derived by conducting statistical analysis on large databases with a strong focus on historical price movements, they tend to prefer statistical expressions of risk such as beta.
In layman terms, academic finance defines beta as a measure of a stock’s volatility in relation to the overall market and/or a benchmark. Therefore, the statistical measure “beta” fits very nicely into their statistical models such as the capital asset pricing model (CAPM). This is a model that allegedly calculates the expected return of an asset based on its beta versus expected market returns.
More traditional definitions of risk are favored by old-school, business owner oriented, fundamental investing proponents. To the fundamentalist, risk is more about more practical matters such as the loss of purchasing power, or more directly the outright loss of capital.
Definitions of Beta
[drizzle]Academics in finance love to utilize and present fancy and complex mathematical formulas applied to comprehensive statistical analysis in order to present and support their theories on investing. Admittedly, it is quite impressive and even cerebral looking to most of us laymen lacking the complex mathematical skills to interpret what we are seeing. However, just because something looks impressive and even complex, doesn’t necessarily mean it’s smart or even true.
The following are some basic definitions of beta that in themselves illustrate what I consider as a penchant for taking the simple and making it complex:
Investopedia offers the following definition: of beta:
“Beta a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.”
“In finance, the beta (?) of an investment is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate either an investment with lower volatility than the market, or a volatile investment whose price movements are not highly correlated with the market.
Beta is used in finance as a measure of investment portfolio risk. Beta in this context is calculated as the covariance of the portfolio’s returns with its benchmark’s returns, divided by the variance of the benchmark’s returns. A beta of 1.5 means that for every 1% change in the value of the benchmark, the portfolio’s value changes by 1.5%”
Why I Am Writing This Piece?
Importantly, if you really carefully consider the above definitions of beta, it should be clear that they are full of theory, but not necessarily full of fact. A beta attached to an individual company suggests that the company stock price will move in direct proportion as the market moves according to the relationship depicted by the beta. For example, if a company has a beta of 2, this suggests that it will move up or down twice as much as the market over a given period of time. Unfortunately, at least for the academics, the stock price of an individual stock doesn’t always behave precisely as theory suggests.
Nevertheless, if a company does in fact have a high beta, many investors will automatically assume that it is a high risk stock. This became vividly clear to me as a result of comments made on my most recent article on Johnson Controls (JCI). It started with one individual suggesting that, and I quote: “according to Yahoo Finance, the beta for JCI is over 1.5, and the yield is only 2.1%. How can a poor retiree live on 2.1% with such a high risk stock?”
You see, part of the problem is that this individual opined that JCI is a “high risk” stock simply because it has a high beta. Frankly, I don’t believe this person is alone, as many additional people chimed in expressing their displeasure regarding investing in a high beta stock. On the other hand, other readers commented and offered support for the research recommendation as well as their disdain for beta.
From my own perspective, the bigger problem is that based on fundamentals, JCI is in truth a very high quality company and certainly worthy of consideration for retiree’s portfolios. Especially for those retirees that are in need of achieving a higher total return on a part of their portfolio that many higher-yielding dividend growth stocks do not offer.
What I believe that all boils down to is that I will concede beta to be a moderately relevant measure of price volatility. However, I do not concede that volatility is necessarily risk. In fact, at the right valuation high beta could be more of an indicator of extraordinary opportunity than high risk. At extremely high valuations a high beta might imply significant risk. However, high valuation represents high risk, even on a low beta stock.
I am an ardent supporter and believer in value investing. Therefore, I simply cannot accept the idea that beta can be a measure of risk when a company’s valuation is sound or low. Investing in a great business when its valuation is low represents opportunity, not risk. When I do come across great businesses at sound valuation, if it did in fact have a high beta, I would consider that a major plus, not a negative.
High Profile Critics of Beta
Since the individual that initiated the discussion on beta in my article loves it when I include Warren Buffett quotes in my articles, I will accommodate by starting with comments made by Warren Buffett in his 1993 Chairman’s Letter to shareholders:
“The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”
Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks – that is, their volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute with precision the “beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.
For owners of a business – and that’s the way we think of shareholders –