Control Your Emotions, Be Disciplined

Volatility Should Not Be Confused With Risk

Examine the charts provided below and consider which asset you would prefer to trade.

Take a second to think about it before reading on.

I assume that most readers will opt for Asset C. After all, why accept high volatility when the capital value appreciation is linear without turbulence?

I must confess, it was a deceptive question. All three charts depict the same data which is the performance of the S&P 500 Index for a one year period from the beginning of December 2019 to the end of November 2020. Now you will see that all three start and end in the same place.

The difference is deliberate to demonstrate how abstract the concept of volatility can be.

• The green line illustrates the perspective of an individual monitoring market prices daily. Here he will witness exogenous macro-economic influences, swings in the sentiment of Mr Market from manic depression to over exuberance and the impacts of quarterly or semi-annual earnings reports.

• The blue line represents the market experience of someone checking prices once every month - he won’t see much of the interim noise and so the price oscillations will appear smoother and less severe.

• The orange line portrays the viewpoint of a person who only assesses the market once a year and so ignores all of the noise.

Most investors have developed a potentially hazardous fixation on volatility and on market prices generally.

The best investors avoid this pitfall. They monitor prices daily or even at intra-day intervals, which is dangerous. The better approach is to have conviction in your investments and then to ignore the market entirely.

“Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market. I never attempt to make money on the stock market. I buy on the assumption that they'd close the market the next day and not reopen it for 10 years. If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.” Warren Buffett

Monitoring volatility was initially a modest component of sound risk management, but has now evolved into an all-encompassing force: Investment decisions are increasingly driven by volatility data.

Volatility doesn’t equal risk. Volatility is often just distracting noise.

Measuring the volatility of an asset is an art form not a science. The result depends entirely upon the time interval used, as demonstrated above. If you were to measure volatility in minutes rather than days then it would appear even worse than the green chart above.

This is significant because checking prices daily increases the likelihood of succumbing to panic selling during market troughs, and panic buying for fear of missing out (FOMO) when irrational exuberance sets in.

Regulatory initiatives, such as mandatory alerts after a 10% market decline, further contribute to potential volatility driven panic among investors.

Contemplate the fact that Wall Street places a strong emphasis on quarterly figures, short-term guidance, and earnings targets. But why? Numerous external factors exist that are entirely beyond the control of management. Who saw Covid19 coming? Who knew that a Russian invasion of Ukraine would result in a sharp and sudden spike in inflation and interest rates? Why set fixed targets in an ever changing and unpredictable world? Despite being common practice, it is entirely irrational behaviour.

When a CEO's primary concern is to avoid missing a quarterly target, decisions are driven solely by that immediate goal. This frequently leads to significant opportunity costs, as the focus shifts away from what is genuinely in the best long-term interests of the business.

Investors create this situation by demanding guidance and so may be said to be their own worst enemy. They distract management from focusing on sustainable growth and on the prosperity of the company in which they are invested.

When Jeff Bezos was once asked about the quarterly numbers that he had just released, his response was to dismiss the question stating that the quarter had been baked-in three years ago and that he was currently working on doing what was in the best interest of the company five years into the future.

This is the way that a company ought to be run, and the way in which shareholders ought to want it to be run. But alas most don’t get it.

The limitations of volatility data extend to what can be termed a 'Minsky moment.' This occurs when an asset exhibits minimal volatility for an extended period, attracting speculative demand that builds up hidden risks until a breaking point is reached.

Think about government bonds during the ZIRP era. Interest rates were ridiculously low and so bond prices were excessively high, but there was no volatility because this status quo persisted for years. The lack of volatility was misconstrued as risk being low, so money flooded in to overpriced fixed income assets. Then suddenly ‘BOOM’. Inflation hits, interest rates spike, bond prices collapse and many funds were hit very hard. Some collapsed entirely.

Private equity is another interesting case in point. A private company has no market price against which to benchmark its value, so it becomes impossible to witness market driven volatility swings. Instead, valuation markers are created infrequently when each new fund raising round completes. With so few data points, a private enterprise will appear to have a less turbulent valuation curve when compared to exchange-listed companies which are subject to minute by minute price fluctuations - but only a fool would believe that private equity is less risky.

In conclusion, effectively managing risk lacks a straightforward, standardized approach. While data can provide valuable insights, it is no substitute for a qualitative human-driven evaluation of the tangible risks and rewards associated with an asset in the real world. If you are able to analyze the asset and build a sufficient degree of confidence in its ability to yield an attractive return, ignore market volatility.

As Buffett once said, “the market is there to serve you, not to inform you”. Use it to transact, but otherwise disregard the noise that it creates or else you too will become unnecessarily distracted and that will force bad investment decisions and poor outcomes.