Speaking of risk in previous post, I think it’s appropriate to elaborate further on what risk is.
In general term, risk means the possibility of a loss or damage.
In stock market, wall street likes to associate risk with volatility. The general stock market volatility is measured at beta = 1. An individual stock is considered more risky if its beta is greater than 1 (its volatility is greater than that of the general market). An individual stock is considered less risky if its beta is lower than 1 (its volatility is lower than that of the general market).
There is a flaw in this association. For example, consider that the stock market is volatile for 3 years but the starting and ending point are about the same, that is, flat. Now, let’s assume there are stock A and B being priced at about the same earnings multiple with similar return on capital and margin in the market. If stock A is growing fast and raising its earnings by 10% per year, its share price is likely to rise along. Similarly, if stock B is losing its earnings by 10% per year, its share price is likely to fall. The beta for these two stocks, though won’t be the same, will be greater than 1.0. By the standard definition of beta, both stocks are riskier than the general market.
Now, when you own the share of a solid company that is growing its earnings, how would you consider it riskier than a general market that is not going anywhere? Similarly, for a company whose earnings are falling, how can you say it has the similar risk to that of a company that is growing well? This doesn’t make sense.
After all, beta is just a measure of the volatility of the stock relative to the general stock market. It’s not a measure of risk. How volatility is perceived as a risk, perhaps, becomes more meaningful to speculators/traders. Because speculators have short term view and their goal is to time the purchase and sale of the stocks better than others, short term volatility has larger impact to them.
For long term investors, volatility becomes less significant. Stock investing is an investment in a company just like owning a house. When you own a house, you don’t bother so much about its daily fluctuation in the price. Except when someone comes knocking at your door offering ridiculously attractive price that is hard to refuse, you usually ignore people telling you how much your house is worth on a daily basis. What matters to long term investor is that how the company is doing. If it’s making good rate of return on its capital, its share price will eventually reflect it. Holding a portfolio of stocks whose earnings are marching upwards in aggregate over time, you know that the market value of this portfolio will rise along eventually, if not ahead of time. That’s how you make money in stock market.
Some people say stock market is risky. Now, consider this portfolio of good companies whose earnings, in aggregate, are rising as the years go by. If you don’t need to use some money for next 10 years and you invest it in this portfolio of good companies, 10 years later you could see the market value of this portfolio more than doubling and so is your money. Will you consider it risky to hold this portfolio? Riskier than putting your money in the deposit that earns less than 1% interest rate while the inflation is 2%?
To be successful in investing, you have to view volatility differently than the market. When your goal is to own a part of a good company with good earnings, then you can see volatility as your friend. History has repeatedly shown that the market will go to extreme optimism and pessimism along the time. That provides opportunity for you to take advantage, buy during extreme pessimism (and probably sell at extreme optimism). If you can’t control your emotion and you view volatility as risk, then you are not ready to invest in stock market. Once you can control your emotion, then the next thing is to let your mind and observation work by finding a portfolio of good stocks. Where to find and how? We will cover it in other post later.