Academia’s definition of risk: beta — a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns (from Investopedia).
Another way of saying that: volatility = systematic risk.
By comparison, here is what value investors have said about risk/beta/MPT over the years:
Warren Buffett (“The Super Investors of Graham and Doddsville” speech): “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.”
Seth Klarman (“Margin of Safety”): “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 $50 per share would not be a lower-risk investment than the same IBM at $100 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.”
Whitney Tilson & Glenn Tongue, T2 Partners (2006 Annual Report): "Risk to us has little to do with the short-term volatility of stock prices; rather, we define risk as the chance of permanent capital loss. Thus, we pay little attention to the short-term gyrations of the market, other than to take advantage of occasions when we believe the stocks of companies we own or would like to own become significantly undervalued, in which case, we buy. Conversely, periods of overvaluation are opportunities to sell.”
Charlie Munger (Stanford University Law Address, 1996): “But the whole law experience would be much more fun if the really basic ideas were integrated and pounded in with good examples for a month or so before you got into conventional law school material. I think the whole system of education would work better. But nobody has any interest in doing it.
And when law schools do reach out beyond traditional material, they often do it in what looks to me like a pretty dumb way. If you think psychology is badly taught in America, you should look at corporate finance. Modern portfolio theory? It’s demented! It’s truly amazing…”
Oh yeah, most importantly about beta — it doesn’t work:
James Montier (“CAPM is CRAP,” see article for chart): “The chart below plots the average return for each decile against its average beta. The straight line shows the predictions from the CAPM. The model's predictions are clearly violated. CAPM woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta stocks. Over the long run there has been essentially no relationship between beta and return.”
Many people probably wondered whether or not they still teach this garbage considering that it is illogical and more importantly, doesn’t represent reality; unfortunately, as a recent college graduate, I can tell you it was a focal point of my education, which I received from a respected university.
Thankfully, admission to Buffett & Munger U is lifetime enrollment and not a four-year experience.
Another way of saying that: volatility = systematic risk.
By comparison, here is what value investors have said about risk/beta/MPT over the years:
Warren Buffett (“The Super Investors of Graham and Doddsville” speech): “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.”
Seth Klarman (“Margin of Safety”): “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 $50 per share would not be a lower-risk investment than the same IBM at $100 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.”
Whitney Tilson & Glenn Tongue, T2 Partners (2006 Annual Report): "Risk to us has little to do with the short-term volatility of stock prices; rather, we define risk as the chance of permanent capital loss. Thus, we pay little attention to the short-term gyrations of the market, other than to take advantage of occasions when we believe the stocks of companies we own or would like to own become significantly undervalued, in which case, we buy. Conversely, periods of overvaluation are opportunities to sell.”
Charlie Munger (Stanford University Law Address, 1996): “But the whole law experience would be much more fun if the really basic ideas were integrated and pounded in with good examples for a month or so before you got into conventional law school material. I think the whole system of education would work better. But nobody has any interest in doing it.
And when law schools do reach out beyond traditional material, they often do it in what looks to me like a pretty dumb way. If you think psychology is badly taught in America, you should look at corporate finance. Modern portfolio theory? It’s demented! It’s truly amazing…”
Oh yeah, most importantly about beta — it doesn’t work:
James Montier (“CAPM is CRAP,” see article for chart): “The chart below plots the average return for each decile against its average beta. The straight line shows the predictions from the CAPM. The model's predictions are clearly violated. CAPM woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta stocks. Over the long run there has been essentially no relationship between beta and return.”
Many people probably wondered whether or not they still teach this garbage considering that it is illogical and more importantly, doesn’t represent reality; unfortunately, as a recent college graduate, I can tell you it was a focal point of my education, which I received from a respected university.
Thankfully, admission to Buffett & Munger U is lifetime enrollment and not a four-year experience.
