Investors in stocks have experienced a relatively high degree of volatility in the past year. Indeed, last year's S&P 500 bear market included a 29% fall in the index's price level within a three-week period in March 2020.
Since then, the stock market has also experienced periods of high volatility. This could mean that some investors are dissuaded from purchasing equities – even when they appear to be undervalued.
However, high volatility is omnipresent in equity markets. It is not a reason to avoid buying and holding stocks. Of far greater relevance and importance is the potential for a permanent loss of capital.
Volatility measured by beta
All too often, investors focus on volatility when measuring risk. For example, they may consult a company's beta when assessing its investment appeal. This measures how much its stock price is expected to change relative to the wider market. A figure of more than 1 suggests the stock in question will move to a greater extent, and be more volatile, than the stock market. A figure of less than 1 suggests the opposite.
However, long-term investors may find beta, or any measure of volatility, unhelpful in determining the risk of a specific investment. After all, an investor who has a five or 10-year investment horizon is unlikely to find a stock that displays high volatility over a period of days or weeks detrimental to their investment aims.
A permanent loss of capital
A far more accurate and useful representation of risk is the consideration of a permanent loss of capital. This is where a stock declines to such a level that an investor either loses all of their initial investment, or a substantial part of it. It does not factor in volatility, since a volatile stock can recover from temporary periods of decline. Instead, it aims to assess what the long-term prospects of a business could be based on its fundamentals.
This view has been echoed by a wide range of value investors over many years. Among them is founder of Himalaya Capital management, Li Lu (Trades, Portfolio), who once stated:
"In my view, the biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. Not only is the mere drop in stock prices not risk, but it is an opportunity. Where else do you look for cheap stocks"?
Determining the prospect of permanent losses
Assessing the potential for a permanent loss of capital is subjective. Unlike beta, it does not produce a single figure that can be used to easily compare two different companies.
Instead, it requires analysis of a company's fundamentals to determine its risks. For example, it may include an assessment of its balance sheet strength in terms of debt levels and access to liquidity. Similarly, it may depend on the strength and reliability of a company's cash flow. Also of key importance is the strength of the firm's economic moat and long-term growth strategy.
All of these factors can provide a useful insight into the risks present for any company. They are more subjective and complex than considering volatility, via beta, to measure the riskiness of a specific stock. This could be a reason why the investment industry prefers to consider a company's volatility, since it is an objective and simple measure.
However, focusing on company fundamentals to contemplate the potential for a permanent loss of capital can lead to a more relevant measure of risk for long-term investors. This could result in a more efficient allocation of capital.
Read more here:
- Benjamin Graham on the Dangers of Momentum Investing
- Seth Klarman on the Benefits of Dollar Cost Averaging
- Warren Buffett on the Importance of Holding Cash
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