Mental Models discussed in this podcast:
- Velocity – Direction matters
- Relative vs Absolute measures
- Volatility / Beta
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You can find out more information by listening to episode 11 of this podcast.
Price Risk – Show Outline
The full show notes for this episode are available at https://www.diyinvesting.org/Episode36
What is Risk?
- Merriam Webster has a few definitions for us:
- Possibility of Loss or Injury
- Someone or something that creates or suggests a hazard
- The chance of loss or the probability of loss
- The chance that an investment (such as a stock or commodity) will lose value
- What this should suggest to you is that there are many different types of risk.
- This is especially true for investing risk. Each type deserves its own discussion and it would be a mistake to believe that
- Two Key Elements to risk:
- Negative Event
Volatility / Beta – the size of uncertainty or risk related to the size of changes in a security’s value. (Reference: Investopedia)
- Problems: the definition of volatility is based solely on the size of fluctuation.
- The more volatile the stock, the riskier the stock. However, this fails to account for only negative volatility. Instead, you can calculate high volatility for a stock that goes up quickly. This would not be a risk though. High returns are the exact opposite of risk.
- Often used as a relative measure. Relative measures are not useful to an individual investor, because all they care about is their own personal results. The focus should be on absolute results.
Price Risk – The potential for short-term downside fluctuations in stock price below the intrinsic value of the company and below your purchase price
- Focus is only on the downside
- Highlights the importance of price fluctuations being short-term in nature
- Price relative to intrinsic value is what matters
- Price relative to your purchase price is important solely for the psychological harm it can cause if you lack the proper temperament for long-term investing.
- Unavoidable – present in all investments
- Can be mitigated by only purchasing stocks below their intrinsic value. Purchasing overvalued companies will increase your price risk.
Risk involves two key elements: Uncertainty and Negative Events. Volatility and Beta are false measures of investments and make key errors in their assumptions. They measure both upside and downside price movements as risk and they equate stock prices to stock values. You should ignore calculated measures of volatility in your investment decisions. Price risk is the key focus. Price risk is the potential for short-term downside fluctuations in stock price below the intrinsic value of the company and below your purchase price. You can mitigate price risk by only buying companies below their calculated intrinsic value.