Wednesday, February 15, 2012

Risk vs. Volatility

In the financial industry, the word "risk" gets thrown around quite frequently but its definition is fairly loose.  Today, we will take a look at how it relates to the term "volatility".  We will find that a stock investor should actually like risk as it is traditionally defined (i.e. volatility).

Risk as Volatility is usually a pretty good place to obtain conventional wisdom on investing.  So, let's see how it defines risk.   It basically says 2 things.

Risk is:
1) the chance that an investment's actual return will be different than expected, or
2) standard deviation of the historical returns or average returns of a specific investment.

The two actually say the same thing.   The former is a more down to earth language and the latter is just more mathematical.  At first sight, they sound pretty fair.  For an investment to be risk free, we should know what its expected return should be and the chance that it deviates from it should be very, very low.  Sure, that is exactly what volatility means, but does volatility really equate to risk?  I would argue not quite.

Volatility is Not Risk, But Opportunity
First and foremost, this is not exactly the same definition as we understand the word "risk" to mean.  The Webster dictionary tells us that risk is "the chance that an investment (as a stock or commodity) will lose value", when it is dealing with investments, and I would 100% agree with this definition.  But going back to the financial industry's definition of risk as volatility, we see that it falls short.  The definition speaks nothing about the performance of an investment.  If an investment's expected return is -5% per year and it hits that target bang on every year, by this definition, it is a "risk free" investment.  Moreover, it negates the fact that an investor is able to take advantage of volatility to increase his/her returns.  Lastly, an investment is determined solely by its volatility and is independent of what price one had paid when one first buys the investment.

So how did we get here?  Many academics and other smart people use this definition.  Almost every major financial institution will use this definition of risk to calculate the risk in their portfolios.  I believe it all stems from the random walk theory.  The random walk theory posits that the movement of the price of stocks are randomly distributed.  Thus, past price movement do not predict future price movements.  If one subscribes to this theory, it would be natural for one to define risk as we see it defined by the financial industry.  Since we can't know future price movement, the greater the fluctuation an investment has, the greater risk it contains because at any given moment, its price can either go up or down.

Figure 1: Investments with Low and High Volatility

If we look at Figure 1, we can see two investments.  Investment 1 is depicted by the blue line.  It fluctuates very little.  Investment 2, depicted by the red line, fluctuates a lot.  However, in the end of our time horizon, they both reach the same level.  Conventional wisdom tells us that Investment is riskier because it has more volatility.  Since the random walk theory tells us that we can never predict movements, we are as likely to buy at B and sell at C (i.e. lose money) as we are to buy at A and sell at D (i.e. make money).  Along the same line of thought, the theory implies that the stock gurus like Warren Buffet are as successful as they are because they got lucky.  Warren Buffet is as lucky as you would be lucky if you were blindfolded and threw a dart and hit the bullseye.  Since there are so many stock investors out there, there's bound to be a few that get really lucky and outperform the market.

As you have already guessed, I don't buy into this theory.  Warren Buffet and the like do so well because they are able to accurately determine a stock's intrinsic value.  With volatility, the price of a stock would sometimes drop below that of its value.  This is the time when Buffet buys.  When volatility brings the stock price above its intrinsic value, Buffet sells.  Buy low, sell's really that simple!  Even though stock movements may be random, it does not mean that you have to buy or sell the stock at random times!

If we are able to reliably buy at points A, C and E, and sell at points B, D, and F, respectively, the risk of Investment 2 may be even lower than that of Investment 1.  It is, therefore, entirely possible that you are able to have a safer investment with higher returns!

So What is Risk?
So, we are back to square one.  What is risk?  I would go ahead and re-state Merriam-Webster's definition, that risk is "the chance that an investment (as a stock or commodity) will lose value".  It's actually a pretty good definition.  To personalize it a little more, I would like to add your investment goal in there somewhere.  Perhaps the definition should go something like this: risk is "the chance that an investment will not meet your investment goal."  With this definition, an investment's risk becomes much more relevant.  Many new questions surface, such as, "What is the current inflation rate?", "What is the intrinsic value of the stock?", "What was my purchase price relative to that intrinsic value?", "What are my investment goals?", etc.

In the end, you want your investment to give you returns higher than inflation so that you're actually making money!  You also need to have an investment goal so that your portfolio matches that goal.  If you intend to make $1 million in 10 years and you're starting with $10,000, good luck with that CD (or GIC)!  A CD may give you a volatility-free investment, but the risk that you will not meet your investment goal is 100%!

Where Does This Leave Us?
If you buy into what I said above, the obvious question becomes: how do we determine when the price of a stock is below its value?  There are many investing techniques out there that are based on the fundamental analysis of a stock (looking at its intrinsic value).  And if you have followed this blog, you would know that I am a big fan of Phil Town's Rule #1 Investing.  It's a great and easy way to figure out if a company is "investable" and if its price is sufficiently below its value for you to make your purchase.  Go ahead and click on the link above and see what Rule #1 Investing is all about!