If you thought last year was bumpy—you would be exactly right about the 4th quarter. The 4th quarter of last year delivered a dramatic loss of 14% for the S&P 500 Index. This felt terrible for someone with $1M dollars to see a decline in their portfolio of $140,000 in 3 months. This doesn’t mean there was a realized loss of value or that you were forced to sell anything at the current price, BUT the emotions that come with this are uncomfortable nonetheless. The majority of investors claim they are invested for the long haul without a need to sell anything for living expenses—and for these people maybe these bumps don’t matter. Others use their portfolio as a retirement account and make withdrawals on a consistent basis and this loss of value becomes “realized” when you sell in down markets. For both types, emotions get the best of us (even for the buy and hold investors). Equity alternatives to the S&P 500 are low volatility index funds, which were down significantly less (roughly 7% and 9% for the ones we hold at BCM) in this same time period.
What do you think of when you think of volatility? I think of turbulence, big swings up and down, and general uncertainty. It’s uncomfortable. Most people think that the extra “risk” in volatile stocks would also warrant higher returns. Intuitively, this would make sense—you are taking the extra risk to weather the spikes up and down and in return you hope to receive higher returns. Why else would you CHOOSE this path over a smoother ride.
Warren Buffet made his fortune in investing in low volatility, value stocks (think insurance and other “boring” value stocks). He was able to do this because he understood that higher volatility did not always provide higher returns. This is due to a number of reasons you would not expect.
- First, investors and brokers are lured into volatile stocks because of the promise of higher returns. Investors have an irrational preference for lotteries and gambling with the hope of winning big.
- Secondly, brokers (supposedly the “smart money”) who work for these big wire-houses are judged based on how they are “tracking” the market on a monthly basis. This naturally discourages the investment in low volatile stocks (as they are usually undervalued in an index weighted with market capitalization). Each month, their jobs and livelihood depend on how they are doing—they have to perform in the short run. In some cases, investment brokers will even give up better investments to keep their performance close to their benchmarks.
- Finally, if investors and other brokers are flooding into these highly volatile stocks the prices are driven up (supply and demand). The value increases for these low volatility stocks through lower pricing and steady appreciation.
So, does risk correlate with volatility? Maybe not. As Buffet states: “Risk is simply the probability of losing your initial investment. Risk comes from not knowing what you’re doing.” Most of our clients are aware that we take the opposite view than the masses (and one closer to Buffet) in that we believe short-term swings in the market are distractions and not a real indication of stock value and future performance. We are NOT benchmarked against any index in the short term so we are able to weather short swings and invest in funds that add value and protection in volatile markets.
We see risk as real changes in asset prices. Three things can affect the change in stock prices.
- A change in the fundamental value of an asset (this is a logical change).
- Uncertainty over the fundamental value of an asset and our “investor reaction” to uncertainty.
- Investors reacting to the behavior of other investors (momentum) or anticipating how they think other investors will behave.
Markets are knee-jerk and spontaneous. Volatility can be similar to the economic cycle (expansion, peak, decline, trough). It is created by our behavior – our emotions, our loss aversion, our bias (hindsight looking back)—and this all drives our future behavior. It is often frustrating, frequently illogical; however, it is a reality and it matters. The best we can do is stop chasing volatility and invest in something that performs well (and better) in uncertain times.