How to Measure Risk

Investing in stocks is a risky business. There are some risks you have some control over and other that you can only guard against. Thoughtful investment securities selections that meet your goals and risk profile keep individual stock and bond risks at an acceptable level.

However, other risks inherent to investing you have no control over. Most of these risks affect the market or the economy and require investors to adjust portfolios or ride out the storm.

There are two ways to measure risk. One is by using modern portfolio theory and the capital asset pricing model and the second is to look at the various risk factors which affect a business.

Capital Asset Pricing Model

We will not discuss in detail this theory of asset pricing as it requires you to have a working knowledge of first or second year university level statistics and finance. Since this is an introductory article, readers who are interested to learn more about the CAPM and Modern portfolio theory are encouraged to attend a course in finance or seek advice from a qualified advisor.

Basically, the CAPM makes some major assumptions about investors and their preferences. In order to use the CAPM to find the proper discount rate, one must know three things: a stock's beta, the nominal risk free rate, and the expected return on the market. Stock's with betas greater than one are more risky than the market and betas of less than one are less risky. For example, a stock with a beta of 1.5 is expected to gain 1.5% when the market rises 1%.

Modern portfolio theory is also where the main ideas about diversification come from. We will look at this concept in more detail later. For now, we can define a diversified portfolio as containing securities which have little or no correlation to other securities in a portfolio or the market. These securities are then placed in a portfolio in such a way as to minimize the volatility of the portfolio.

You may be scratching your head by now but this is essentially the basic concept of diversification and minimizing risk. There are a lot of disadvantages and advantages to using the CAPM and MPT. One assumption of the CAPM I will mention is that there are two types of risk. Market risk and firm specific risk. The CAPM assumes that investors only get a premium return for taking on market risk because the firm specific risk can be entirely eliminated through diversification. Thus, beta only measures market or nondiversifiable risk.

Second Way to Measure Risk

The second way to measure risk is to start by taking a nominal risk free rate. How do you do this? Well you take the yield that is currently offered on US Government bonds that match your investment horizon. For example, if you plan to invest for 5 years, you should use the yield on 5yr U.S. bonds. Now add to this the premium for risk and voila-you have your required return or discount rate. You may be asking, what makes up the risk premium? Well, remember from lesson one there are five things: financial, business, liquidity, foreign exchange, and political risk.

Financial Risk:

Financial risk involves a company's capital structure. What is their debt/equity? What is their current ratio? etc. We will look into how to assess financial risk in greater detail later in lessons on accounting and financial statements analysis.

Business Risk:

This involves the economics of the firm you are looking at. Ask yourself, how will this company look ten years from now? Do they have barriers to entry? (ie patents, economies of scale etc. more on this in the economics lessons).

Liquidity Risk:

It has been shown through various studies that firms which are private or thinly traded are sold at a significant discount to their value compared with similar firms with active markets. Firm's which can be easily bought or sold with little transaction costs are called liquid or marketable. The lack of liquidity can occur if the stock you are researching is not widely followed. It can also happen if you plan to liquidate a large block of stock. Your transaction could bring down the price significantly.

Foreign Exchange/Political Risk:

This involves firms which derive significant portions of their sales overseas. For example, many exporters to Asia have been affected by weaker demand for their goods. Foreign Exchange/Political risk can also happen because the company you are looking into is heavily restricted by the government. Finally, different countries have different accounting rules so you should be aware of this when investing in foreign stocks.

When investing in foreign stocks, you also run the risk of the U.S. appreciating. To adjust for this, you should restate your foreign returns to U.S. returns.

Source: http://www.everythingaboutinvestment.com/2012/01/how-to-measure-risk.html

Why does Warren Buffett avoid technology stocks?

• Warren Buffett prefers to invest in companies which operate in fairly stable and certain environments. Technology sector is the last place to look for certainty.
• He values certainty of returns more than the potentially huge but risky returns.
• He believes predicting the economics of the fast paced technology sector is far beyond his competency, probably a strong reason for his avoidance of the sector.

Warren Buffett has often been in the news for avoiding investments in the technology sector, which has been viewed by many investors as a highly lucrative sector. The Oracle of Omaha has his reasons for this approach. We look into reasons for his avoidance of the hot stocks.

Warren Buffett has historically preferred investments in sectors or companies which are unlikely to experience major changes. In his 1996 letter to shareholders he stated,

“We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now.  A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”

Warren Buffett loves to have certain but stable returns over potentially huge but risky returns.  In the same letter he also states:

“Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will the inevitables.  But I would rather be certain of a good result than hopeful of a great one.”

It shouldn’t be assumed that Mr. Buffett despises change. He is only averse to change when evaluating as an investor. In his own words:

“Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good.  As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration:  We applaud the endeavor but prefer to skip the ride.”

In his 1999 letter to Shareholder’s Mr. Buffett highlights the fact that he and his partner Charlie prefer to operate within their level of competence and identifying a durable competitive advantage in the technology space is beyond their combined expertise. In Buffett’s words,

“Our problem -- which we can't solve by studying up -- is that we have no insights into which participants in the tech field possess a truly durable competitive advantage. Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie and I have no special capital-allocation expertise.  If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter.”

Has Warren Buffett’s stay out of the technology sector impacted the returns of his investments? Well let’s look at the numbers over the last two decades.  The chart below compares the 20 year CAGR of the S&P 500, Berkshire Hathway’s (NYSE:BRK.A) book value per share and Berkshire Hathway’s Market value per share.

20 year CAGR in S&P 500 and Berkshire Hathaway share price and book value

Berkshire’s book value per share has grown at a CAGR of 14.6% over the last 20 years (1993-2013) while the Market price per share has grown at a CAGR of 12.7%. This growth has solidly beaten the S&P 500’s 20 year CAGR of 7.1%. It is clearly seen that Buffett’s decision to stay away from the technology world hasn’t hindered the performance of his investments. And what is the secret of the Oracle of Omaha?

Warren Buffett has this great quality which investors often call ‘Discipline.’ It is clearly evident in his avoidance of the technology sector, even during the boom of late 1990’s, when every other person was investing to set up a business which had something to do with internet. Though in hindsight Buffett had the last laugh, non-entry into what appeared to be a highly lucrative sector is a proof of the Oracle’s discipline. There are notable exceptions in the technology world, where stocks like Apple & Google have created tremendous value and returns for shareholders. Apple stock price has grown at a 10 year CAGR of 36.7% while Google stock has grown at a 10 year CAGR of 27%. While critics could view these as Buffett’s big misses, we view it as a proof of his disciplined approach to investing. Sticking to your rules is hard to do and that is something every wannabe successful investor needs to learn from the Oracle of Omaha.

In conclusion, Warren Buffett side stepped the tech boom for the following reasons: Buffett was uncomfortable investing in companies operating in rapidly changing environments; He could never find the competitive edge in any technology companies that he felt was durable; and as he admitted, forecasting the long term business economics of internet companies was beyond his competency.

We at Amigobulls live in the exciting world of technology stocks. While we salute the Oracle of Omaha for his discipline and wisdom, we will continue to make our humble attempts to apply his principles in the technology sector and pick value stocks from this sector. We invite our readers to let us know their experiences with technology stocks. Happy investing with Amigobulls.

Source: http://amigobulls.com/articles/why-does-warren-buffett-avoid-technology-stocks