What is risk?
According to modern portfolio theory, risk is equivalent to volatility. The more volatile the asset price is, the higher the risk. Academician translates the volatility to beta. The market risk has a beta of 1.0. Higher risk will have beta > 1.0 and lower risk will have beta < 1.0.
Utilities companies have beta of less than 1.0 because of its higher earnings stability and less volatile share price. Semiconductor companies have beta of greater than 1.0 because of its lower earnings stability and more volatile share price. You can see the beta for different industries in US in this link: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
Many successful investors have rebutted the definition that risk = volatility, and I am on their side. Let’s take a simple example. Assume the market is relatively flat with low fluctuation in the past 3 years. Market’s volatility has beta 1.0. A company that doubles its revenue and earnings in 3 years sees its share price up by 80%. Because of rising share price and higher volatility, the beta is greater than 1.0, implying that the risk is higher than general market. Now, this is a company that sells daily grocery and doubles the number of stores in 3 years. It has stable profit margin, no debt and lacks competition in its neighborhood. How can its risk be higher than general market’s?
Another example. A hospital’s earnings growth slows down from 20% per year in the past to 5% per year now and foreseeable future. As many investors are disappointed that it has turned from a fast grower to a slow grower, they dump the stocks. The P/E ratio falls from 20x to 10x, hence the share price falls by nearly 50%. This hospital, with falling share price, will also have beta greater than 1.0 despite its stable margin and earnings. Again, beta fails to paint the picture fairly.
I think the reason why academician defines risk as volatility is because it’s convenient and measurable. They want to translate risk to one number that can be compared across all different assets easily. Historical share prices can be easily obtained and its volatility measured. All this can be done by computer, and now, we can quantify risk as one number. The reasoning is just flawed.
Unfortunately, beta is fed into Capital Asset Pricing Model (CAPM), which is used to measure cost of equity, which, in turn, is used to calculate (estimate) cost of capital. This whole process is quite systematic and becomes the standard way to calculate cost of capital, taught at schools and practised by professionals.
In Howard Marks‘s book, The Most Important Thing, there is a good discussion on risk, and I recommend you to read it. In summary, risk is subjective, unquantifiable and deceptive. You can’t quantify risk into a number and and there is often a hidden risk. Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.
Let’s apply that definition to business and stock market.
To a business, risk is uncertainty about its future earnings. The more uncertain the future earnings, the higher the risk. An airlines business has higher risk than a grocery business.
To stock market, risk is more than just uncertainty about earnings. There is an element of price that you pay for the share. The higher the price you pay relative to earnings, the higher the risk. The greatest risk does not come from the low quality business of high volatility. It comes from paying prices that are too high relative to the earnings. In extreme bull market, the risk is highest because most people ignore the risks, believing that share prices can continue to climb. This leads to overpriced stock market that will eventually collapse under its weight.
As an investor, you have to recognize investment risk as: 1) business risk and 2) the price you pay. For business risk, you have to understand the business, whether it can continue to operate profitably in the future. For the price, your guidance is on value. If you know the value of the company, then you know what price you need to pay. This is an essential component of dealing successfully with risk. The value you estimate has actually included the business risk into consideration.
Higher risk does not mean higher return. Higher risk may mean higher promised return, but it also comes with higher probability of loss. You have to understand this right. Many people assume that if they take higher risk, they will be rewarded with higher return. This can’t be true because if riskier investments reliably produced higher returns, they wouldn’t be riskier!
Stock market is not a static arena in which investors operate. It is dynamic and shaped by investors’ behavior. When everyone ignores risks and keep bidding up the prices, it becomes very risky. When everyone is risk-averse, their unwillingness to buy usually reduces the share prices to the point that it becomes not risky.
If this post is to be summarized into one sentence about recognizing risk in stock market, it will be this quote from Warren Buffet:
Be fearful when others are greedy and greedy when others are fearful.
If you know nothing about stock market and still want to invest in it, then use above sentence as the guidance on the general risk level in stock market. When everyone is risk-averse (usually after stock market crash), it indicates that the risk is low. When everyone keeps buying regardless of price, it indicates high risk.
For most investors, their investment results will be determined more by how many losers they have, and how bad they are, than by greatness of their winners. If you lose 50% in one year, you need 100% return to recover fully.