Value Investing - Risk vs Beta

Both Warren Buffett and his mentor Benjamin Graham — founder of Value Investing — have said that risk has nothing to do with beta, or volatility.

Benjamin Graham

Graham wrote that the secret to successful investing is the Margin of Safety. In other words, the best performing investors were those who minimized risk. The first step to controlling risk is understanding that risk has nothing to do with volatility.

In current mathematical approaches to investment decisions, it has become standard practice to define “risk” in terms of average price variations or “volatility.” See, for example, An Introduction to Risk and Return, by Richard A. Brealey, The M.I.T. Press, 1969. We find this use of the word “risk” more harmful than useful for sound investment decisions — because it places too much emphasis on market fluctuations.

Benjamin Graham, Chapter 5: The Defensive Investor and Common Stocks, The Intelligent Investor.

Warren Buffett

Buffett too explained the disconnect between the two, in his 1984 talk at Columbia University about Graham's principles.

"Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms."

"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 who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland."

Seth Klarman

Seth Klarman — value investor and chief executive of the Baupost Group — further expanded on the concept as follows:

"The Capital Asset Pricing Model (CAPM) relates risk to return but always mistakes volatility, or beta, for risk. Modern Portfolio Theory (MPT) applauds the benefits of diversification in constructing an optimal portfolio. But by insisting that higher expected return comes only with greater risk, MPT effectively repudiates the entire value-investing philosophy and its long-term record of risk-adjusted investment outperformance. Value investors have no time for these theories and generally ignore them."

"academics and many professional investors have come to define risk in terms of the Greek letter beta, which they use as a measure of past share price volatility: a historically more volatile stock is seen as riskier. But value investors, who are inclined to think about risk as the probability and amount of potential loss, find such reasoning absurd. In fact, a volatile stock may become deeply undervalued, rendering it a very low risk investment."

Seth Klarman, in his 2008 preface to Graham's book Security Analysis.

Graham, Buffett and Klarman are all saying here that — contrary to what academics say — volatility has little bearing on investment worthiness; and that volatile stocks can even be highly profitable.

Advanced Graham Screener

Customized Value Investing

Buffett Explains

On Academic Finance

Graham Resources