Determinant 3: The degree of risk

Determinant 3: The degree of risk

Risk plays an important role in the stock market, no matter what your overeager broker may tell you. There is always a risk – and that’s what makes it so fascinating. Risk also affects the valuation of a stock. Some people think risk is the only aspect of a stock to be examined.

The more respectable a stock is – that is, the less risk it has – the higher its quality. Stocks of the so-called blue-chip companies, for example, are said to deserve a quality premium. (Why high-quality stocks are given an appellation derived from the poker tables is a fact known only to Wall Street). Most investors prefer less risky stocks and, therefore, these stocks can command higher price-earnings multiples than their risky, low-quality counterparts.

While there is general agreement that the compensation for higher risk must be greater future rewards (and thus lower current prices), measuring risk is well-nigh impossible. This has not daunted the economist, however. A great deal of attention has been devoted to risk measurement by both academic economists and practitioners. Indeed, risk measurement is so important that an entire part of this book (Part Three) is devoted to this subject.

According to one well-known theory, the bigger the swings – relative to the market as a whole – in an individual company’s stock prices (or in its total yearly returns, including dividends), the greater the risk. For example, a nonswinger such as AT&T gets the Good Housekeeping seal of approval for “Widows and orphans.” That’s because its earnings do not decline much if at all during recessions, and its dividend has never been cut.

Degree of Risk. Photo by Elena

Therefore, when the market goes down 20 percent, AT&T usually trails with perhaps only a ten percent decline. At&T is probably not as safe as it was before 1983 divestiture and deregulation, which led to increased competition in the telecommunications industry. Nevertheless, the stock still qualifies as one with less than average risk. Amdahl, on the other hand, has a very volatile past recorded and it characteristically falls by 40 percent or more when the market declines by 20 percent. It is called a “flyer,” or an investment that is a “businessman’s risk.” The investor gambles in owning stock in such a company, particularly if he may be forced to sell out during a time of unfavorable market conditions.

When business is good and the market mounts a sustained upward drive, however, Amdahl can be expected to outdistance AT&T. But if you are like most investors, you value stable returns over speculative hopes, freedom from worry about your portfolio over sleepless nights, and limited loss exposer over the possibility of a downhill roller-coaster ride. You will prefer the more stable security, other things being the same. This leads to a third basic rule of security valuation.

Rule 3: A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

We should warn the reader that a “relative volatility” measure may not fully capture the relevant risk of a company. Part Three will present a thorough discussion of this important risk element in stock valuation.