A Different Perspective on Risk – Part 2
In part 1, I made my case that the price of a stock related to value should be heavily factored into any discussion of risk in holding stocks. In this part, I am going to present a simple model for thinking about risk which expands on a more traditional view to include price.
**Disclaimer – this is meant to be an article about a conceptual treatment of risk. Don’t be fooled by the graphs, there is nothing precise in my discussion.
I’m going to start with a simple claim that the price movements of a stock can be broken down to two components:
1) Real Changes in the Economic Drivers. By this I mean changes in interest rates, inflation, the business cycle, the industry, the competitive position and actual developments at the individual firm etc.
This is obviously a complex issue that varies from industry to industry and from firm to firm. For simplicity, we will model this type of risk as normally distributed around an expected return (similar to the CAPM).
2) Changes in Investors’ Perceptions of Firm Value.
In the short-term, stock prices can make volatile moves seemingly detached from underlying value. The internet bubble, the housing bubble, and the market movements at the end of 2008 are poignant examples.
However, in the long-term, changes in investors’ perceptions of firm value tend to converge to underlying fundamental value. This isn’t just a theory, there are several mechanisms in the market that encourage this, including: dividends, share buybacks, corporate acquisitions, spin offs/liquidations, and other investors searching for bargains.
Example A: Stock Price Determined Solely by Economic Drivers
This is what the returns on a stock might look like if they were only determined by changes in the overall market (what I’m calling changes in Economic Drivers). In other words, it is assumed that the stock is fairly valued and that its annual return is symmetric about the expected return – as determined by the growth rate of the economy and the riskiness of the stock.
Strange as it seems, this is similar to the treatment of risk of many relative performance funds.
Example B: Stock Price in One Year Fluctuates Around Fair Value
This example assumes the stock begins the year undervalued by 25% and that its price ends the year symetrically distributed around the fair value. If this were the reality of how stock prices fluctuated, this is what the returns might look like for this stock.
Example C: Stock Returns Are a Combination of Randomly Changing Economic Drivers and Convergence to Fair Value
This third example assumes that both the force of random (or at least difficult to predict) underlying economic forces and a tendency to converge to fair value drive the price of stocks. To generate this chart, I assumed the returns are 50% driven by each factor. Again, in no way am I claiming this is an accurate representation of actual returns, just a conceptual view of how different forces contribute to stock returns.
The blue line below shows the returns for a 25% undervalued stock whose return is driven in this manner.
So What Does Any Of This Mean?
Unfortunately you never get to see the probability distribution of your stock returns a year in advance. However, my personal investment thesis, and the subject of this blog, is that Value Investing – the systematic purchasing of securities that are fundamentally undervalued and the systematic selling of securities that are fundamentally overvalued – will uncover far more investment opportunities that resemble the blue line in Example C. And that by consistently applying these principals of investment strategy, a diligent investor can achieve higher returns with at lower risks.