According to modern portfolio theory, risk can be divided into two elements: systematic risk and unsystematic risk.
Systematic risk – also called undiversifiable risk or market risk – is the risk inherent in the overall market and is not specific to a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification.
Unsystematic risk – also called nonsystematic risk, specific risk, diversifiable risk, or residual risk – is the company- or industry-specific risk that is inherent in each investment. This type of risk can be reduced through diversification. By owning stocks in different companies, different industries, and different types of assets and securities, investors can be less affected by an event or decision that has a strong impact on any single asset.
This distinction should make intuitive sense.
If you own only one stock, then the systematic and unsystematic risk in your one stock portfolio is very high. The stock market could tank (systematic risk) or your company could lose a key customer (unsystematic risk).
But if you own 1,000 stocks – like you might if you own an index fund – then the systematic risk in your 1,000 stock portfolio is unchanged but your unsystematic risk is almost zero, so the overall risk is lower. Yes, the stock market could still tank (systematic risk), but if one single company loses a key customer (unsystematic risk) – or even goes bankrupt – then your entire portfolio would only be slightly affected.
For the average investor, diversification reduces risk because it reduces unsystematic risk.
The Problem with Modern Portfolio Theory
Although the difference between systematic and unsystematic risk might make sense, modern portfolio theory (MPT) takes a wrong turn into la-la land when it tries to explain how to measure risk.
According to modern portfolio theory – which is taught in business schools everywhere – an asset’s exposure to systematic risk is measured by its beta (β).
What is beta?
In MPT, the beta (β or beta coefficient) of an investment measures an asset’s exposure to systematic risk by indicating whether it’s more or less volatile than the market.
A beta less than 1 indicates that the investment is less volatile than the market, while a beta more than 1 indicates that the investment is more volatile than the market. Volatility is measured as the fluctuation of the price around the mean (i.e. the standard deviation).
MPT says that risk = reward, so a highly volatile stock should have an equally high required rate of return – which means that a business with a highly volatile price would also have a very low intrinsic value (risk = reward, high market price volatility = low intrinsic value).
Why beta doesn’t make any sense
Honestly, beta is a ludicrous concept and I find it upsetting that it’s still taught as a fundamental concept in almost every business school.
Why is beta so dumb?
First of all, beta uses market prices to measure risk – instead of using fundamentals. As Ben Graham used to say:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Market prices often have nothing to do with the underlying economics of a business. So how can market prices tell us anything about the riskiness of a business?
Secondly, financial theory says that a stock whose price drops by a large amount (i.e. a high beta stock) is more risky than a stock whose price hasn’t dropped by that much. But if the underlying economics of a business that is selling for $100 a share haven’t changed, has that business suddenly become more risky if its price drops to $50 per share?
Definitely not! In fact, the stock would now have a higher margin of safety and should properly be considered less risky.
For a value investor, this should come as no surprise. We like to buy dollar bills for $0.50 and would be even happier if we could buy a dollar bill for $0.40.
“I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share.
Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value.
Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment’s volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk.“
“The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since you don’t have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that’s not a difficult job.”
“The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury.’“
So to Buffett, risk has nothing to do with volatility. Risk is simply the probability of losing your initial investment. If there is a chance that he might lose money on an investment, then Buffett simply doesn’t invest.
But where does risk come from then? Certainly not from stock prices.
The answer is simple:
“Risk comes from not knowing what you’re doing.” – Warren Buffett