There is a widely held belief in risk management circles that the risk of a particular stock (or any other type of asset) can be estimated from its historical volatility. That is, the more the price of a security has changed in the past, the less safe it is as an investment.
Numerous value investors have disagreed with this interpretation of risk. Howard Marks (Trades, Portfolio), for example, believes that risk is related not to volatility, but to valuation - a highly volatile small cap stock purchased at a bargain price can be a safer investment than an expensive blue-chip stock that was bought at an inflated price.
This dovetails quite well with the everyday experience of most ordinary people. For the layperson, the risk of an investment is understood to be the probability of capital loss, not whether the price of the asset has fluctuated in the recent past. For instance, if someone looking to buy a home was presented with the opportunity to purchase a property that had undergone a 25% price drop due to some exogenous market factor, they would consider this to be a golden buying opportunity.
Viewed through this lens, volatility is not something to be feared, but to be embraced. A rational investor bases their assessment of a company on fundamentals like its debt level, overall balance sheet health, current cash flow, a reasonable projection of futures cash flows and so on. The fact that the price of its stock may have undergone wild swings recently says a lot about the buyers and sellers of that particular stock, but nothing of substance about the company itself.
Do it like Buffett
At the 2007 annual Berkshire Hathaway (BRK.A, BRK.B) investor conference, Buffett was asked to comment on this exact concept. Unsurprisingly, he did not think that volatility measures risk. Instead, he seemed to think that the general academics of risk management have a poor understanding of how to manage risk in the real world. According to him, the large amount of data available in the stock market has led to an overly mathematical approach to investing that doesn’t actually accord with reality, that it is "nice and mathematical and wrong."
So where does risk come from? For Buffett, risk arises from the economics of a business. Investing in some industries is inherently more risky than investing in others - early-stage biotechnology being an extreme example. It also comes from not understanding the underlying company that you are investing in. According to Buffett, if you know your business down to brass tacks and know that the price you are buying it at is a good one with a wide margin of error, then you run no real risk at all. And if volatility can aid you in securing such a bargain, then all the better.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: How Passive Investing Affects the Market
- Why Can Stocks Jump on Bad News?
- The Problem With Social Trading and Blindly Following
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