http://www.brickfinancial.com/thethirdpig/archive/2008/01/volatility_is_not_risk.html
Posted by Ben Taylor on January 11, 2008 12:42 PM
Excerpt from Brick Financial's June 2006 Client Letter:
We believe that risk should be measured as the probability of permanent loss of capital. Too many professional and novice investors alike measure risk in terms of price fluctuations. An unfortunate byproduct of this view is that the more risk one takes on, the higher one’s potential returns. In other words, high beta stocks should garner high returns. As it turns out this is not really true. We pointed to Robert Haugen’s book, The New Finance, in our February Client Letter as providing evidence that low beta (low risk) stocks actually perform better in the long term than do high beta (high risk) stocks. Another side of this coin is labeling stocks risky or not risky by the beta or fluctuation compared to the market is foolhardy.
By way of example, let’s say we buy the stock of a company for $50 per share. In our analysis we have estimated the stock of this company should be selling for something close to double that price in the range of $90 to $110. In this example, we have very little risk as we wait for the market to recognize what we have and close the price to value gap by purchasing the stock at increasing prices. But if the stock suddenly falls in price to let’s say $30, the beta of the stock actually increases. The stock has become more volatile thus conventional wisdom says it has also become more risky. If the value of the company has remained unchanged, then the reality is the stock has become less risky as its price to value ratio has become more favorable – the proverbial margin-of-safety has increased. In this example an investor would have the opportunity to by an asset worth a $1 for just 30¢. Prior to the price decline that investor would have only been able to by that $1 for 50¢ although a fifty cent dollar is nothing to sneeze at.