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.
Many fundamental analysts estimate value by projecting cash flows and then discounting at a rate determined by measuring the beta of the stock. The CAPM and many analysts who use betas to discount cash flows are assuming that risk can be summarized by one number, and that that one number can be determined by observing how the stock price historically correlated with the returns of other stocks.
But let’s do a quick thought experiment to see how ridiculous this is….