Top stocks to invest in – When Does Volatility Equal Risk?

Top stocks to invest in

Volatility is one of the biggest risks in investing according to conventional financial wisdom.

A small minority of investors, mostly value investors — a group to which I belong — take a different view. We think it is the probability of permanent capital loss, not volatility, that constitutes the real risk.

Neither perspective is entirely correct. Nor are these the only two viewpoints — one in which volatility is the main investment risk and another wherein volatility is cast as unimportant. Rather, the right question to ask is: When does volatility equal risk?

Judging investment performance starts with the implicit assumption that the unit of risk is a measure of the portfolio’s volatility. Many metrics — the Sharpe ratio, tracking error, and information ratio, for example — compare a unit of return to a unit of portfolio volatility, measured either on an absolute basis or relative to a benchmark.

A generally accepted belief is that a below average rate of return achieved with low volatility can be considered an exceptionally good result, and most conventional investors avoid volatility at all costs, particularly given the pervasive short-termism of the investing industry.


Why Value Investors Don’t Regard Volatility as Risk

Warren Buffett famously said that as a long-term investor he would “much rather earn a lumpy 15% over time than a smooth 12%.”

Following his logic, many modern value investors aren’t concerned with volatility. Instead, they focus their risk management efforts on decreasing the probability of permanent capital loss. After all, these investors believe they have the emotional fortitude to ride out the short-term ups and downs as long as the strategy and long-term results are sound.

Volatility as a Source of Risk Is Not Absolute, But a Function of the Investor’s Circumstances

Consider the following four investor profiles and how volatility is likely to affect their long-term investment results:

  1. Long-Term Investors with Strong “Stomachs”: Such investors have a 10-year or longer time horizon as they save for goals like retirement or college tuition for their children. Furthermore, these investors are behaviorally unaffected by volatility — they stick to the investment plan regardless of how bumpy the ride. For such investors, volatility is not a risk. Their main consideration is the long-term annualized rate of return and the probability of permanent capital loss along the way.
  2. Short-Term Investors: This cohort plans to use a major portion of their portfolios within the next three years. Volatility is a primary risk since the near-term withdrawal of capital will lock in short-term results. So volatility is a primary concern, because as it increases, so too does the potential for forced sales at disadvantageous prices.
  3. Long-Term Investors with Weak “Stomachs”: These investors are behaviorally affected by volatility. Many investors saving for long-term goals end up taking investment actions counter to their interests because of price volatility, market news, or other short-term developments. Ideally, these investors should not act in this manner given their goals, but they can’t stay rational and so frequently sell at low points. This type of investor should treat volatility as a risk since a more volatile return stream is likely to create worse financial outcomes.
  4. Long-Term Investors Who Consistently Spend Small Portions of Their Portfolios: This variety of investors could include institutions, such as an endowment that spends approximately 5% of its portfolio to support its organization, or an individual using a small portion of the portfolio to cover annual expenses. Volatility matters to some degree, but it is not the main risk.

Here are two Monte Carlo simulations of a scenario similar to those facing many endowments today:


Scenario 1

Expected Return = 8%, Standard Deviation = 15%,

Annual Withdrawal Rate = 5%, Number of Years = 30
top-stocks-to-invest-in


Scenario 2

Expected Return = 8%, Standard Deviation = 10%,

Annual Withdrawal Rate = 5%, Number of Years = 30
top-stocks-to-invest-in


The above analysis demonstrates that when the volatility of returns, as measured by the standard deviation, falls from 15% annually to 10%, the probability of the portfolio failing to last the full 30 years drops significantly — from 14% to 3%.

There are two lessons here: First, know your client’s situation so you can determine how important a risk portfolio volatility is in their specific case.

Second, do your best to condition clients to be long-term investors with strong “stomachs” for a substantial part of their portfolio. For more on this, please see “How and Why to Be a Long-Term Investor.” This will give you and them the freedom to maximize long-term returns without worrying about short-term volatility and will put them at an advantage over many other market participants.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/draco77


Gary Mishuris, CFA

Gary Mishuris, CFA, is managing partner and CIO of Silver Ring Value Partners, an investment firm with a concentrated long-term intrinsic value strategy. Prior to founding the firm in 2016, Mishuris was a managing director at Manulife Asset Management. From 2004 through 2010, he was a vice president at Evergreen Investments. Mishuris began his career at Fidelity as an equity research associate. Mishuris received an S.B. in computer science and an S.B. in economics from the Massachusetts Institute of Technology (MIT).

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