Investing: Properly Defining Risk

Many in the financial world define risk using some sort of variance measure, like beta. This, in my mind, is a foolish attempt to quantify something that can only loosely be quantified. Finance is not a hard science.

Warren Buffett often points out the absurdity of using beta as a measure of risk with the following example: if KO were to decrease in value by 50% tomorrow, is it a better buy or a worse buy? It is a better buy, of are buying the same thing for less. However, a 50% decrease in value in one day would lead to a high beta for the stock.

A much better definition of risk is one articulated by Ron Muhlenkamp in his book Harvesting Profits on Wall Street. Ron defines risk as the possibility of a long-term, permanent reduction of purchasing power due to 1) taxes, 2) inflation, and/or 3) capital loss. Individual investors can outpace taxes and inflation buy making sure they invest in equities instead of bonds, providing of course they have a long enough investment time horizon that they can ride out the volatility. Minimizing capital loss, then, simply means buying stocks trading with sufficient margins of safety. No regard for beta is necessary.

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