Monday, April 9, 2007

What is Risk?

I'm reading David Dreman's book Contrarian Investment Strategies in the Next Generationand Chapter 14 is titled "What is Risk?". According to the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT), risk is measured by volatility or beta. The greater the volatility or beta, the higher the risk.

However, one of the main advocates of EMH & MPT, Eugene Fama, subsequent to his 1992 paper, famously declared "beta as the sole variable in explaining returns on dead...Knowing the volatility of an equity doesn't tell you much about the stock's return."

David Dreman published this article in Forbes Magazine in 2001.

A more comprehensive criticism may be found in here.

And of course, there's Warren Buffett's take on EMH and MPT:

"To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices."

As Dreman says, "sometimes even the bluest of blue chips tumble sharply and become very volatile for a while. This volatility is not something to shy away from, it's a gift of opportunity. For value buyers, the more a stock is driven down by panic selling, the better. People warned away from this volatility lost enormous potential profits".

I tend to agree with this thinking, which is why I don't use volatility to measure risk. I believe, as David Dreman and Warren Buffett does, that risk is measured by the companies financial strength and it's stock price in relation to the fundamentals (i.e. intrinsic value vs stock price).