Chapter 14. Risk and Volatility: How to Think Profitably about Them

[W]e define risk, using dictionary terms, as "the possibility of loss or injury."[127]

Warren Buffett

What does the word risk mean? Think about it. Because of the U.S. government guarantees, U.S. Treasury bills and bonds are considered to be the least risky securities around the world. In this context, risk implies default risk or downside risk. Following this line of thinking, corporate bonds are riskier than U.S. bonds, common stocks are riskier than corporate bonds, and options are riskier than common stocks. However, when academics mention that common stocks are riskier than corporate bonds, they invariably imply that common stocks have a higher "beta." In simple terms, beta measures how stock returns are correlated with market returns: The higher the correlation, the higher the beta, with the average beta of all stocks being normalized to 1.0. However, in most research studies, beta has not been found to be a useful definition for predicting common stock returns, especially for individual stocks.[128] So, academics are still trying to develop better measures of risk. In the meantime, as an individual investor, you are better off ignoring beta for picking individual stocks. You should instead carefully differentiate between the downside risk and the upside potential. At the very least, you should know what you mean by the word risk.

A vague understanding of risk is a dangerous thing. Consider the well-known case ...

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