Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition

CHAPTER 2

Upside, Downside: Understanding Risk

Risk is part of investing, and understanding what it is and how it is measured is essential to developing an investment philosophy. In this chapter, we lay the foundations for analyzing risk in investments. We present alternative models for measuring risk and converting these risk measures into expected returns. We also consider ways investors can measure their risk aversion.

We begin with an assessment of conventional risk and return models in finance and present our analysis in three steps. In the first step, we define risk in terms of uncertainty about future returns. The greater this uncertainty, the more risky an investment is perceived to be. The next step, which we believe is the central one, is to decompose this risk into risk that can be diversified away by investors and risk that cannot. In the third step, we look at how different risk and return models in finance attempt to measure this nondiversifiable risk. We compare and contrast the most widely used model, the capital asset pricing model (CAPM), with other models, and explain how and why they diverge in their measures of risk and the implications for expected returns.

We then look at alternative approaches to measuring risk in investments, ranging from balance-sheet-based measures (using book value of assets and equity as a base) to building in a margin of safety (MOS) when investing in assets, and present ways of reconciling and choosing between alternative measures ...