How Can You Measure The Risk Of A Share?

1st Feb '12 by Edward Croft

2 comments 14574 reads

For some reason they let the loons out of the mad house in finance a long time ago. These loons came with PhDs, prizes and all kinds of fancy equations and for the traders who worked so hard in their spare time to get minor letters after their name like MBAs or CFAs they were too much to resist. These crazy fools suggested that the risk of a share could be quantified as its volatility - essentially how much it wiggled around on a day to day basis. For whatever reason (Emperor's New Clothes springs to mind?), this has been taken as complete gospel by the finance world who have embedded this volatility measure of risk into all their risk management, portfolio rebalancing and option pricing models. Given its hand in the design of the credit crunch and the downfall of countless hedge funds, we've all seen how well that turned out! But still this idea persists...

Surely it's just common sense to know that risk isn't a number? You may be able to quantify it in vague terms, but you can't pin it down precisely. For the father of value investing, Benjamin Graham, risk was the 'permanent loss of capital'. I think we can all intuitively relate to Ben Graham's definition over the definition of the finance academics.

Three more sensible ways to think about Risk

The much heralded James Montier wrote prolifically on the topic of risk while he was global equity strategist at Soc Gen. Montier has studied Graham religiously and wrote a famous paper that summarised Graham and his own thinking on the subject.

Graham - via Montier - proposed three primary sources of risk to your investment in shares or any other asset - Valuation Risk, Earnings Risk and Financial Risk - each of which should be seriously considered when purchasing a new position.

Valuation Risk - For Ben Graham the primary measure of valuation was what is now known as the Graham & Dodd PE - or the price divided by 10 year average earnings. This form of smoothed earnings ensures that investors don't get carried away by cyclical peaks in the business cycle. As Graham said - "We would suggest that about 16x is as high a price as can be paid in an investment purchase of a common stock" ... "the danger in growth stocks is that for such favoured issues the…

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UK Value Investor

2nd Feb '12

Hi Ed. This is always an interesting topic. Fundamentally they're confusing risk and uncertainty.

If I have two very pleasant outcomes (make up your own) but I don't know (and don't care) which one I'll get, then there is uncertainty but no risk.

If I jump off of a tall building then there is a lot of risk but little uncertainty.

If you're a buy and hold investor who owns the FTSE 100 via some tracker and you're only after the income then the volatility of the market value is not relevant, so beta does not measure your risk. In this case risk is the risk of a falling real dividend payout.

Beta is only a measure of risk if you're going to be a seller at some point soon and you don't want to make a loss.

It's still a useful measure if you're doing a Modern Portfolio Theory style asset allocation portfolio, but it just isn't a sensible measure of risk for most people as you say.

And Montier's points about real risk are of course much more sensible. Permanent, not paper loss is all that matters.

Although I guess I would say that beta can become risk if people are scared of share price falls, which of course they are.

This isn't what the academics are talking about but I think it's a better way to correlate beta and risk for the average investor.

I've seen this often enough to know how damaging it can be.

From 2001 to 2003 there were massive market falls and even though the intrinsic value of the market hadn't really changed, many people I know sold out on the way down out of fear, driven purely by the essentially meaningless falls in the index level.

So beta can be a measure of risk, but only in that it drives investors to do stupid things that lead to a permanent loss of capital (because after selling at the bottom they buy bonds or something and totally miss out on the post-crash rally).

How can you measure the risk of a share?

Three more sensible ways to think about Risk

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Edward Croft

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