Risk and Volatility
What does the word risk mean? In most research studies, researcher has been using BETA to measures how stocks returns are correlated with market returns. The higher correlation, the higher the BETA, with the average BETA of all stocks being normalized to 1. However, the BETA has not been found to be useful definition in predicting common stocks returns, especially individual stocks. So, in the meantime, as an individual investor, you are better off ignoring beta for picking individual stocks. You should instead carefully analyse the downside risk and the upside potential for a better stock analysis. In this point, you should be able to define the risk in your own term. A vague understanding of risk is a dangerous thing which eventually leads to better management of investment.
Warren Buffett suggests that returns from quarter to quarter or year to year are meaningless if the returns in the long run are predictable. Volatility of returns in the short run should not be the main criterion for assessing the risk involve. The important is the returns in the end of the investment period planned. Given an example of a 30 years investment plan of a 5% yielding Treasury bond. You earn $50 interest yearly which the market to price of the bond will change from month to month depending on the market interest rate, which normally will create short term volatility. If your initial plan is to invest 30 years, will you define the monthly volatility risk? The investment is risk free concerning the payment is in nominal dollars.
The main reason for this is, there is an interaction between the length of holding period and risk. This is not just applying to bond which normally has a longer investment period, but also to stocks. If stocks returns from one period to another were statistically independent, the length would not be important. However, based on experience and study, that the stock volatility in the long run is lower than volatility in the short run. Thus, the length of investment is an important factor to be taken as consideration for an investor.
Volatility = opportunities?
An investor if he sees the volatile as a risk will avoid volatile stocks, which may not be the correct investment approach. Indeed, I would like to suggest the opposite as a true investor like Buffett is welcoming volatility. Consider volatility from the size of the firm, smaller companies normally are more volatile than larger companies, probably because of smaller number of buy and sell orders can affect the companies stocks dramatically. But think of this way, small companies do not need to be fundamentally risky if you have study the company thoroughly when you investing in it. Smaller companies offer opportunities because the amount of money is easier to manage thus generate higher returns. Increased in volatility does not mean increase in risk, this does not imply because volatility might cause by many other factors that might not have anything to do with risk. One has to differentiate this.
Usually after an earning is announce, a company’s stock price become more volatile. Such a rise in volatility does not mean that the stock has become risky. Volatility can cause a sharp decline in stock prices and this might offer an opportunities. However, unless you know the reason of the sharp decline, you should not increase your investment in stocks simply because their prices have declined. A careful study will keep you out from catching a falling knife. Always apply the value investing and growth investing skills to your study for stocks assessment.
But history teaches us that when a price rapidly goes down, the probability of finding good stocks or businesses at lower prices goes up. Remember always that even though you cannot predict the downfall just as we cannot foresee a coming crash, we should not feel comfortable predicting a quick recovery.