When we find an attractive stock to invest in, we outlay money, aka invest, to earn an attractive return and the investment will involve a degree of risk.
One of the most dangerous, commonly accepted and ill thought out concepts in investing is the risk/return trade off.
- Fund of funds Business Keeps Dying
- Baupost Letter Points To Concern Over Risk Parity, Systematic Strategies During Crisis
- AI Hedge Fund Robots Beating Their Human Masters
That is: high returns equals high risk.
Unfortunately, Investopedia continues to spread this type dogma, as you can see by the graph below.
Volatility (standard deviation) is not risk!
The appropriate definition of risk is from the Oxford dictionary (or any other branded non-financial dictionary) as: Exposure (someone or something valued) to danger, harm, or loss.
And in particular to investing, the risk is absolute loss.
Don’t take my word for it, let’s see how other successful well known investors define risk.
Howard Marks talks about, in this interview with the Manual of Ideas team, risk and how it is tied to superior returns.
“Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”
Seth Klarman wrote that risk is: “described by both the probability and the potential amount of loss.”
And Warren Buffett concluded that, “Risk comes from not knowing what you’re doing.”
But why do so many financial commentators continue to talk and write about it? Probably due to not having skin in the game, there is no loss to them if a reader drinks their cool aid and loses money.
From the unhelpful Investopedia graph above, we see that volatility is referred to as standard deviation, essentially changing an age old definition of risk. This, so-called risk, is referred to as Beta in the market.
…and BETA IS NOT RISK!
Beta is a measure of volatility, the movements of share prices, but it was created to allow a pointless comparison of one stock prices movement to other stocks, and to the market itself as a whole.
The urban dictionary has a more appropriate definition of Beta; a beta is a male who, instead of being alpha and manning up, completely bitches out. Can apply to many situations, but often refers to scenarios with women [and investing].
Guy 1: Bro, hook me up with that girl’s friend. [Bro, the beta on that stock is high]
Guy 2: [Fuck that. I’m going to double up with both of them. Stop being such a beta. [Fuck that. I can earn a high return off that stock. Stop being such a beta boy.]
This example below, is why, assigning risk to beta, and just using beta in general, is a pointless exercise.
Say, for example, we purchased 1,000 shares in XYZ stock at $1 per share and it has a beta of 1.05 (a beta of 1.0 appropriately offers the lowest risk). We fail to do the appropriate analysis and find out XYZ is fraudulent and suddenly declares bankruptcy, resulting in the stock price going to zero.
In this example we have lost 100% of our investment. Simple right. Oh and by the way, that simple example is a real life example, the business was Enron!
Now consider this scenario.
ABC stock meets all our investment criteria, little to no debt, healthy free cash flow and high rate of return on equity, and its stock is trading at a price of one-fourth (1/4) of the then per-share business value of the enterprise. The majority of financial analysts and financial media commentators would have estimated the value of ABC’s intrinsic value at $400 to $500 million. ABC’s market capitalization of $100 million was published daily for all to see.
What is the risk?
Has the fall in ABC’s stock price, now representing one-forth of it’s value, increased it’s risk?
No, the risk hasn’t increased but decreased.
The premise that higher returns equal higher risk is a misguided generalization, not based upon logic.
The above scenario was real, the stock was the Washington Post Company (WPC) and Warren Buffett described the purchase in his 1985 letter to shareholders.
Excerpt below (source). [Emphasis mine]
“We mentioned earlier that in the past decade the investment environment has changed from one in which great businesses were totally unappreciated to one in which they are appropriately recognized. The Washington Post Company (“WPC”) provides an excellent example.
We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.
Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?)
Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.”
This last paragraph is important as it describes one of two important ideas all investors need to apply.
“The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.”
? Benjamin Graham, The Intelligent Investor
As Epictetus recommended in Enchiridion;
‘Impression come to us in five ways: things are and appear to be; or they are not, and do not appear to be; or they are, but do not appear to be; or they are not, and yet appear to be. The duty of the educated man in all cases is to judge correctly.’
In the case of Washington Post: they are, but do not appear to be.
Returning back to our premise of why ‘high risk equals high returns’ is plain wrong, because it is possible to reduce risk and earn high returns. This is exactly what all the great