Real Meaning of Risk

An article I found very interesting (From fool.com)...

The world of academic finance tends to promote the modern portfolio theory, which says that, in investing, risk is equal to volatility. We're taught to look at risk in terms of a stock's beta. But I disagree with the notion that beta is an adequate measure of risk.

Now, I have the utmost respect for all of the teachers in my life -- the value they've added to my career is priceless -- but most academics tend to look at the world in neatly packaged scenarios instead of focusing on real-world applications. In the real world, viewing risk in terms of volatility is mere folly. I can even use a real-world example to prove my point.

An illuminating example
Back in 1973, Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) Warren Buffett began accumulating shares in Washington Post (NYSE: WPO). At the time, the Post owned a top-tier collection of media assets, including Newsweek, the Washington Post newspaper, and several television stations in major markets, and it was selling in the market for $80 million. Buffett concluded that the Post's assets could easily fetch some $400 million or more if they were auctioned off.

Shortly after he made his investment, the stock price declined. With a lower market capitalization, the beta of Washington Post stock would have been higher. So, to people who look to beta as a measure of risk, the Post was now a riskier investment. Yet to this day, I can't understand why it would be riskier to buy $400 million worth of assets for $40 million than for $80 million.

The problem with beta as a measure of risk is that it focuses on the one aspect of a stock price's movement that is of the least importance. Beta fails to consider business risk, asset valuations, and all other fundamentally sound business-like valuations. So the idea of selling a business only because its price has declined is not only silly, but it also guarantees subpar investment results in the long run.

Real risk
So what is risk? Well, risk should be viewed as the likelihood of permanent loss of capital. Betting at a casino is a good example. And it is in this context that the risk-versus-reward profile should be assessed. When you buy shares in a business for $30 apiece because you have determined through data analysis and your reasoning that the shares have an intrinsic value of $60, but then the stock tanks to $20, you have not taken on risk but mere price volatility. Of course, you should naturally go back and determine that the intrinsic value has not materially changed for the worse. If it hasn't, then your investment has really become less risky, and you should view the price volatility as an opportunity to take advantage of a better bargain.

It's this misunderstanding of risk that causes investors undue stress and results in sloppy buying and selling. Buffett used to say that you should be able to watch your investment decline by 50% and not feel pressured to sell. Mohnish Pabrai told me that a stock's price immediately tends to decline whenever he buys a stock and shoot up when he sells, yet the declines don't bother him, since he doesn't concern himself with price volatility.

Indeed, several years back, Pabrai was buying Universal Stainless and Alloy (Nasdaq: USAP) at around $15 a share, after which the stock eventually fell to $5 a share. Sitting on a paper loss of more than 50%, Pabrai viewed the decline as nothing more than excessive market volatility and believed that it had nothing to do with the stock's intrinsic value. He was right -- he sold years later for an impressive profit. If Pabrai had sold out at $5 out of fear, he would have taken a substantial loss in capital and would have been forced to look for a three-bagger just to get back to where he started.

With the right temperament and discipline, investing successfully can be rather simple. Just ask the masters.