The beta of an investment measures the risk exposure of an asset by indicating whether it is more or less volatile than the market. A beta less than 1 indicates that the investment is less volatile than the market, while a beta greater than 1 indicates that the investment is more volatile than the market. Volatility is measured as the fluctuation of the price around the mean (i.e. the standard deviation).
For the majority of value investors: beta is a preposterous concept. It is disturbing (even worrying) that it is still taught as a fundamental concept in almost all business schools around the world.
Beta uses historical market prices to measure risk instead of intrinsic economic fundamentals. As Ben Graham said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine. Market prices can deviate from the economic realities of a business in the short term. If the share price doesn't necessarily tell us a company's intrinsic value, how can it provide a basis for assessing risk?
In addition, beta does not reflect the influence that investors can themselves exert on the risk of their holdings through efforts such as proxy challenges, shareholder resolutions, communications with management or the ultimate purchase of sufficient shares to acquire control of the company and allow it direct access to the underlying securities.
The use of beta is also based on the principle that the upside potential and downside risk of any investment are essentially equal, and are simply a function of the volatility of that investment relative to the volatility of the market as a whole. This principle is also subject to legitimate scepticism. According to Klarman: "Past volatility of security prices is not a reliable predictor of future investment performance (or even future volatility) and is therefore a poor measure of risk. ยป
According to Warren Buffett, risk corresponds exactly and simply to the dictionary definition: "The strategy we have adopted excludes the standard dogma of diversification. Many experts would therefore say that our strategy is riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well reduce risk if it increases, as it should, the intensity with which an investor thinks about a company and the level of comfort he must feel with its economic characteristics before buying it. In expressing this view, we define risk, using dictionary terms, as "the possibility of loss or damage.
For Buffett, therefore, risk has nothing to do with volatility. Risk is simply the probability of losing your initial investment. Over the long term, it is intimately linked to the economic fundamentals of the company in which you invest.
Good luck dear readers and stay safe.