Redefining Risk And Return In Common Stock Investment From A Value Investing Perspective: Some Tenable Propositions Eben Otuteye and Mohammad Siddiquee, Brandes Institute
Abstract
Modern Portfolio Theory, standard asset pricing models and the concept of rational decision makers in efficient markets have major limitations as systems for modeling investor behavior and prices of financial assets. Financial market participants are not a uniform group of rational investors. Instead, they are an amalgamation of heterogeneous traders with varied and sometimes very divergent goals. In fact, not every financial market participant is an investor; a significant number of financial market participants are speculators. Th us, the current paradigm of using Modern Portfolio Theory to represent the activities of market participants as “investor behavior” leads to predictions that do not fit the outcomes that are observed in financial markets. First, we define “investment” and “an investor” from a value investing perspective according to Benjamin Graham. Aft er discussing some of the standard conclusions of Modern Portfolio Theory and traditional asset pricing models, we present a number of propositions to motivate discussion on ways to rethink the current prevailing view of what is investment and who is an investor. Th is is with a goal to nudge academic finance back to the ideas of Benjamin Graham as encapsulated in the value investing paradigm, a system of investment decision making that has withstood the test of time and economic, business and financial cycles for over 80 years. We focus particularly on how investors perceive and handle risk in their portfolio management decisions. We conclude that the core value investing framework, as well as analytical tools and methodology as handed down by Benjamin Graham, are capable and sufficient to develop portfolio theory that incorporates time and investor behavior that is different from the homogeneous group of ultra-rational decision makers on whom the current popular models are based.
Redefining Risk And Return In Common Stock Investment From A Value Investing Perspective – Introduction
“The explanation cannot be found in any mathematics, but it has to be found in investor psychology. You can have an extraordinary difference in the price level merely because not only speculators but investors themselves are looking at the situation through rose-colored glasses rather than dark blue glasses.” – Benjamin Graham.
In modern portfolio theory (MPT), risk (defined as volatility) and return are positively related. While this assertion makes intuitive sense, it is not an accurate reflection of the behavior of decision makers in stock markets or financial markets in general. The goal of this paper is to highlight some of the questionable aspects of standard portfolio theory and asset pricing models that have been taken for granted and to reexamine some of the traditional ways of thinking. In particular, we discuss the use of volatility (either in the form of standard deviation or beta) as the measure of risk and show how it is deficient in capturing the true essence of risk in investment. We start with the assertion that, at present, the concept of risk is both elusive and intractable because of inherent flaws in the definition of investment. Once investment is appropriately defined and clearly distinguished from speculation, and risk is perceived as the possibility of loss of capital rather than volatility of asset prices, it is then possible to model a relationship between risk and return that reflects more accurately what is empirically observed in financial markets.
We use value investing as the standard of investment for purposes of our discussion. A question that immediately arises is “Why value investing?” First of all, since there are many investment styles, explicitly defining a specific investment paradigm helps to anchor the discussion. Second, there is a preponderance of evidence that value investing yields the highest risk-adjusted returns compared to other investment styles (see for example, Tweedy Browne Company, 1992; Fama and French, 1998; Piotroski, 2000; Lakonishok, Shleifer and Vishny, 1994; Chan and Lakonishok, 2004). Thirdly, as we will show in the rest of the paper, risk as defined in value investing is meaningful and well aligned with the goals and psychological disposition of investors and does not have the ambiguities inherent in defining risk either as standard deviation of returns or the beta of an asset.
The main thesis and contribution of this paper to the discussion of risk and return in portfolio management is:
i. to make a case for Graham and Dodd’s (1934) definition as the proper concept of investment from an operational perspective;
ii. to show that the commonly used notions and measurements of risk as volatility are not meaningful indicators of risk given the goal of investment;
iii. to offer a number of propositions aimed at generating discussion as to how to properly characterize risk and return in portfolio management; and
iv. to make a case for making Graham’s principles of value investing the central concepts in investment curriculum both in academia and professional certification (such as the Chartered Financial Analyst or CFA designation).
We will also address issues pertaining to behavioral finance. It is worth noting that, while margin of safety is the cornerstone principle of value investing, investor psychology plays a central role in determining the final outcome of an investor’s endeavor. Although behavioral finance as a distinct discipline of knowledge derives its formal beginnings from the late 1980s and early 1990s, it has always been a central concept in Benjamin Graham’s investment philosophy.
Value Investing
In standard financial economics literature, investment is defined as foregoing current consumption in order to create the opportunity for a higher amount of consumption in the future. While this definition is conceptually correct, it is not operational. Therefore, for purposes of our propositions, we will use Graham and Dodd’s (1934) definition of investment, which has an operational meaning built into it. This approach to investing originated by Graham, as described in Graham and Dodd (1934) and Graham (2006), has come to be known as value investing.3 According to Graham and Dodd (1934):
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” (p. 54)
There are three main aspects to this definition that are very important and worth emphasizing. First, for an operation to qualify as investment, it should be based on thorough analysis. With regard to thorough analysis, Graham’s main advice is for the analyst to establish by means of data, logic and experience the continued profitability and financial stability of the company. Second, there should be a promise of safety of principal. And third, there should be a reasonable expectation of satisfactory return. Both the assurance of safety of principal and expectation of satisfactory rate of return hinge on the concept of margin of safety, which is the central concept of value investing.
This definition serves a dual purpose. It not only defines investment, it also defines speculation. Whereas definitions are typically given in a sentence, this definition of investment is in two sentences, highlighting not only what it is but also what it is not. In the process, it deliberately puts speculation (which unfortunately gets confused with investment quite often) under the spotlight. This is in line with what Graham had stated explicitly—that a fundamental requirement for an investor and his or her advisors is to be sure “particularly as to whether they have a clear concept of the differences between investment and speculation…”4 and “between market price and underlying value,” which we address below.
Value investing as an investment paradigm has one primary overarching distinguishing feature, namely, margin of safety. Margin of safety is the positive difference between the market price of the asset and the asset’s intrinsic value (intrinsic value minus price). What this boils down to in practice is that all value investing decisions culminate in buying an asset only when the market price is significantly below its underlying (intrinsic) value. A disciplined application of the margin of safety principle seeks to protect the investor from losing money and ensure a reasonable expectation of satisfactory returns. Thorough analysis and margin of safety are the value investor’s principal tools for handling risk.
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