Red Pine about risk and volatility – they are not the same
By The Andersens
Volatility in the markets causes many investors to make big mistakes in their investment programs. They tend to buy unwisely in rising markets and sell unwisely in declining markets.
We think this happens because there’s a misunderstanding of what volatility and risk are. The popular view in academia is that volatility is the same as risk, and that the higher the volatility, the riskier the security is deemed to be. Most investors think about risk like the academics do.
Our view is that risk is the potential for permanent loss of capital, while volatility is the fluctuation of security prices tied to financial news, trends, outlooks and the actions of traders and speculators.
When academics measure volatility, they focus on what is happening to stock prices (effect) rather than on why stock prices are doing what they’re doing (cause).
Academics, typically, are not trained or inclined to look at businesses individually from a qualitative, long-term viewpoint. They focus more on generalities than on specifics.
What causes volatility?
- Economies, businesses and interest rates simply do not follow straight lines – they fluctuate.
- Traders and speculators feed the fluctuations (the volatility) as they are always trying to predict/guess market movements and trends.
- This volatility spooks or excites investors into emotional actions, causing more volatility.
- The media also adds to the volatility with their flair for the dramatic.
Our view is that volatility is mostly a behavior issue tied to overreactions to short-term events, and also to the fact that most investors do not have a good understanding of their investments.
What Ben Graham says about risk and return:
The common view is that the rate of return depends on the degree of risk one is willing to assume.
Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on the investing task.
What Warren Buffett says about risk:
Risk comes from not knowing what you’re doing.
We think like Buffett and Graham. We believe risk and return are tied to:
- how knowledgeable investors are about what they are doing;
- the quality of the investment choices they make; and
- whether they’re long-term focused or short-term focused.
Understanding essential investing principles helps you think and act better.