Value investors may find it difficult to look beyond the short run during periods of extreme market volatility. That task has been particularly difficult since the start of this year. The S&P 500 experienced one of its sharpest declines on record in February and March before producing a market rally of over 40%.
However, by following the lead of Baupost Group's Seth Klarman (Trades, Portfolio), you may be able to use short-term volatility to your advantage. His ability to ignore short-term price movements and instead focus on company fundamentals could be key reasons for Baupost Group’s market-beating performance over the long run, in my view.
Risk versus volatility
Investors who focus on the short-term performance of their portfolios during volatile periods may worry about their risk of loss.
However, ‘risk’ and ‘volatility’ are two different concepts. Risk is the potential for an investor to lose money on their holdings. This often occurs when they overpay for a stock through failing to obtain a sufficient margin of safety. Meanwhile, volatility is a short-term fluctuation in a stock’s price that is often due to changing investor sentiment. It is usually temporary in nature.
Therefore, long-term investors should not view short-term volatility as a major concern when it comes to managing their portfolio. It does not equate to a heightened risk of losing money, since paper losses are unrealized until a holding is sold.
As Klarman once said, “Risk is not the same as volatility; risk results from overpaying or overestimating a company’s prospects. Prices fluctuate more than value; price volatility can drive opportunity.”
Focusing on company fundamentals
Instead of worrying about the risk of loss during volatile periods for the stock market, analyzing company fundamentals may be a better use of your time. This will allow you to apportion your capital to those businesses that have the highest chance of surviving the short run, and of delivering a recovery over the long term.
Short-term market volatility can provide buying opportunities among quality businesses. Their stock prices may trade lower for a limited time despite their financial position and outlook being positive. Buying undervalued stocks provides value investors with a margin of safety that may be particularly useful in the current uncertain economic climate.
As Klarman once said, “Quality matters, in businesses and in people. Better quality businesses are more likely to grow and compound cash flow; low quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them.”
Volatility in perspective
Buying stocks during periods of market volatility can be a tough task. It requires a large amount of self-discipline to purchase a stock with sound fundamentals when its price is experiencing a high degree of volatility.
One solution is to put market volatility into perspective. For instance, if you have a long-term time horizon then it does not matter how your holdings perform in the short run. Of far greater importance is the level of return they produce over the long run. Therefore, if you purchase a stock and it quickly falls in price, it is largely irrelevant in terms of its impact on the long-term prospects for your portfolio.
As Klarman once said, "It’s almost like you have to slow the game down…. I can buy this thing for a huge fraction of what it’s worth. What am I worried about if it goes down a little.”
Read more here:
- Is Benjamin Graham's Advice on Value Investing Still Useful?
- Charlie Munger on Improving Your Investing Ability
- Howard Marks on Improving Your Investment Decision-Making
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