The Concept of “Risk” According to Benjamin Graham

Taken from “The Intelligent Investor” 4th Edition. pg 121-122

We should like to point out that the words “risk” and “safety” are applied to securities in two different senses, with a resultant confusion in thought.

A bond is clearly proven unsafe when it defaults its interest or principal payments. Similarly, if a preferred stock or even a common stock is bought with the expectation that a given rate of dividend will be continued, then a reduction or passing of the dividend means that it has proven unsafe. It is also true that an investment contains risk if there is a fair possibility that the holder may have to sell at a time when the price is below the cost.

Nevertheless, the idea of risk is often extended to apply to a possible decline in the price of a security, even though the decline may be of a cyclical and temporary nature and even though the holder is unlikely to be forced to sell at such times. But we believe that what is here involved is not a true risk in the useful sense of the term.

The man who holds a mortgage on a building might have to take a substantial loss if he were forced to sell it at an unfavorable time. That element is not taken into account in judging the safety or risk of ordinary real estate mortgages, the only criterion being the certainty of punctual payments. In the same way, the risk attached to an ordinary commercial business is measured by the chance of its losing money, not by what would happen if the owner were forced to sell.

The bona fide investor does not lose money merely because the market price of its holding decline; hence the fact that a decline may occur does not mean that he is running a true risk of loss.

If a group of well-selected common stock investments shows a satisfactory overall return, as measured through a fair number of years, then this group investment has proven to be “safe”. During that period its market value bound to fluctuate, and as likely as not it will sell for a while under the buyer’s cost. If that fact makes the investment “risky”, it would then have to be called both risky and safe at the same time.

This confusion may be avoided if we apply the concept of risk to a loss of value which either is realized through actual sale, or is caused by a significant deterioration in the company’s position – or, more frequently perhaps, is the result of the payment of an excessive price in relation to the intrinsic worth of the security.

Many common stocks do involve risks of such deterioration. But it is our thesis that a properly executed group investment in common stock does not carry any substantial risk of this sort and that therefore it should not be termed as “risky” merely because of the element of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic-value standards – even if any subsequent severe market decline may be recouped many years later.
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My Views:

Declining dividends may imply the company’s business is deteriorating, unless the company retains its earnings for expansion/development purposes.

Unrealized loss is not considered loss of money until sale happens. Always measure the performance of your portfolio for a fair number of years, at least 3 years. Remember a house is not built overnight, it takes time.

If a company’s earnings are declining, the probability that the price will go down is high. Always evaluate the business performance, not the price. “If a business does well, the stock eventually follows.”

Overvaluation of the business value = high price paid = possibility of loss far outweight possibility of profit. Always insist on wide Margin of Safety. Always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

My current view of the stock market – For the last few months, most retail investors shy away from the stock market. Why?? This can be attributed to several “bad” news, from recession fear in US to political uncertainty in our country as well as recent downgrading by Goldman Sachs and petrol price hike. Is now the right time to invest in stocks?? Who knows? But for me, I care much on the valuation side. I tend to look at the discrepancy between price and value of a business before jump in. Investors should welcome low prices so that they can accumulate more stocks of wonderful businesses. As Warren Buffett said, “Be greedy when others are fearful, and be fearful when others are greedy”. Is now time to be greedy? You decide yourself.