Saturday, March 03, 2007

On risk 1 comments

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With every correction, the issue of risk comes into focus more than the upside potential of a stock. Fundamentally, risk is easy to define: how much we stand to lose if things go wrong. In fact, academically and quantitatively, there is a precise definition: the volatility of returns from the stock. The more volatile the historical returns (eg. +/-20% is definitely volatile) as interpreted from historical stock prices, the greater the "market beta" of the stock and the higher the risk.

Market analysts have always used this measure as a means of characterising the risk of a stock and hence deriving the valuation/target price from there. This is obviously a very convenient quantitative measure because historical market prices are readily available and qualitative measures (eg. business trends) are difficult to quantify for those maths whizzes; however I have always had some major issues with this quantitative description of risk.

Firstly, the way that risk is quantitatively measured. The volatility that characterises risk is measured through the historical stock price trends and fluctuations. Basing on historical price patterns is dodgy because one, it begs the question of how far back the historical data should go, and two and more importantly, it ignores the present and the future projections for the industry/company. I have always felt it more useful if the recent price trends, which tend to be more in touch with present and future fundamental developments, are at least weighted more strongly.

Secondly, is volatility really risk? A highly volatile stock suggests there is high potential downside and high potential upside (from historical trends). Contrast this with credit risk for bonds. Now that is pure downside risk, because if there is no default the investor only gets his interest+principal as specified, nothing more, but in the case of default he might suffer losses. In the equity definition of risk, the investor has as much upside "risk" as downside risk, so is a higher return premium really required for higher volatility? Warren Buffett himself puts it this way: he would accept a lumpy 15% return over a steady 10% return, anyday.

And this brings us to the last point. Is the risk measure of the stock an objective definition that can be applied for every single investor irregardless? Note that I'm not talking about portfolio risk and how investors with different risk profiles choose different portfolios, but rather the individual stock itself. My view is that different investors will see the "risk" of a stock differently, even though there is only one quantitative measure of risk for the stock, commonly measured by its beta. This is because there will be investors who don't mind volatility and therefore will not demand a high return premium, while other more risk averse investors will hate volatility and hence expect disproportionately higher returns. Thus different investors will have different expectations of a stock although there is only one quantitative beta.

What does all this mean? It means that firstly, it is occasionally possible to get good returns on a stock if there is a change in the prospects of an industry or a stock, a turning point, that veers it from a risk profile as suggested by its historical price/return volatility --- which is where superior fundamental analysis and anticipation comes in; secondly, that qualitative interpretation of risk based on industry analysis should be a strong complement to quantitative measures, perhaps even dominate the latter; and thirdly, that what works for other people may not work as well for us ie. seek your own stock picks!





Great post on risk.

2/09/2014 10:39 AM  

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