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RISK APPLIED TO VALUE INVESTING
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In 2, I looked at efficient market theory the notion that stock prices always accurately reflect everything known about a company s prospects and offered countering opinions Here, I ll follow a similar approach in addressing the concept of risk, especially as defined by modern portfolio theory, or MPT MPT, introduced by Harry Markowitz in the 1950s, asserts that risk can be reduced through asset allocation: building a portfolio composed of asset classes (such as stocks, bonds, and cash) with low correlations As noted in 8 when I addressed the benefits of international diversification, correlation refers to how closely returns for one asset class (large-cap, US stocks, for example) mirror returns for another asset class (such as small-cap, non-US stocks) In short, if part of your portfolio is zigging when another part is zagging, the gains help offset the losses While this theory seems logical (and helped earn Markowitz a Nobel Prize), it is vital to recognize how risk in this sense is defined Over the years, investors have adopted MPT s mantra, risk
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VALUE INVESTING AND YOU
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reduction through asset allocation, without perhaps giving much thought to what risks are being reduced by following this strategy MPT is based on the notion of redefining risk as share price fluctuation, or price volatility But the value investor would find this definition unacceptable Value investors do not lose money just because share prices decline, even if they temporarily drop below the original purchase price Commenting on the redefining of risk as volatility at the heart of MPT, Malcolm Mitchell, the managing director of the Center for Investment Policy Studies, wrote, That unsupported and unexplained redefinition confounds what all investors previously thought of as risk and what non-professionals still think it is that is, the possibility of losing money 2 Mitchell adds that, Markowitz did not find a way to measure the risk that investors care about: the risk that arises from an uncertain future, the risk that things will turn out to be worse than we expect He simply ignored that kind of risk and focused instead on variability or, to take the term more commonly used today, volatility Instead of measuring risk, Markowitz demonstrated how to measure volatility in a portfolio Why volatility One obvious reason is that volatility is measurable, whereas uncertainty is not In sum, defining risk as volatility is irrelevant to investors real experiences, and worse, it obscures the true definition of investment risk as the possibility of losing money
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MPT is based on the notion of redefining risk as share price fluctuation, or price volatility But the value investor would find this definition unacceptable
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VOLATILITY AND THE VALUE INVESTOR
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As cited above, volatility is the tendency of a security s market value to fluctuate sharply up or down in the short term For traders who want to sell off their portfolios at a moment s notice, volatility and risk are roughly equivalent But for value investors, who don t have the urge to liquidate their portfolios any time soon, volatility has limitations as a measure of risk In the long term, I consider volatility less significant than the values of the businesses in your portfolio and the prices you paid for those businesses Despite my reservations about the usefulness of volatility as a risk measure, I think it merits addressing in this chapter for the following reasons:
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MANAGING RISKS AND YOUR VALUE PORTFOLIO
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Many investors are volatility-averse and cannot tolerate significant short-term price fluctuations in their portfolios In the academic community, volatility is the only quantifiable measure of risk and is extensively cited in studies of risk analysis Empirical studies also may use beta as a yardstick for risk Beta measures a portfolio s relative volatility against overall market movement rather than against its own historical returns
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Understanding terms such as standard deviation and beta can help investors put them in the proper context when evaluating investment opportunities and monitoring their portfolios Let s look in greater detail at the concept of beta
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