There is a very big difference between volatility and a permanent loss of capital. Volatility measures are based on the average amount that a stock’s price has differed from its mean over a set period. However, relatively volatile stocks do not necessarily produce low returns. Nor are they necessarily at greater risk of leading to a permanent loss of capital. Indeed, even the most volatile stocks can produce relatively high returns in the long run.
Moreover, volatility is a historical measure that may not be accurate in the future. For example, stocks operating in certain sectors could be more volatile than others given certain operating conditions. Those conditions may become more benign in the future and cause lower levels of volatility. Investors who were dissuaded from buying them based on their volatile past may end up missing out on their future prospects.
As such, it is somewhat surprising that many investors seem to focus on volatility instead of the threat of permanent loss. Any stock can recover from a temporary decline in its price that deems it to be relatively volatile, but there is no comeback from a permanent loss of capital.
Focusing on the right risks
Oaktree Capital co-founder Howard Marks (Trades, Portfolio) has previously highlighted the relevance of the threat of a permanent loss of capital. He once said, “The possibility of permanent loss is the risk I worry about.”
Of course, many investors may feel the risk of permanent loss is minimal at the present time. After all, the economic prospects are very positive. Even if they deteriorate because of factors such as the Covid-19 pandemic or other risks, some investors may believe that further monetary and fiscal stimulus will be enacted that pushes share prices to even higher levels.
While this situation cannot be ruled out in the short run, ultimately the economy and stock market have never delivered uninterrupted growth. Similarly, companies shrink in size and experience worsening financial performance on a regular basis. As such, ensuring that all portfolio holdings have minimal risk of permanent loss could be far more useful than worrying about whether their share prices will be volatile.
A simple plan
Clearly, it is impossible to fully avoid the risk of permanent loss when holding equities. By nature, they are risky investments that can lead to losses that are never recouped.
However, investors can take simple steps to reduce the threat of a permanent loss of capital. For example, many companies have increased their debt levels while low interest rates have prevailed in recent years. Rising inflation could lead to higher interest rates that squeeze the profitability of highly indebted companies. As a result, ensuring all holdings have modest leverage could be a prudent strategy.
Meanwhile, ensuring a portfolio has sufficient diversification can help to avoid a large permanent loss of capital. A company that folds will have a smaller impact on a well-diversified portfolio compared to a concentrated group of stocks.
Although such measures will not necessarily reduce volatility, they could lead to a lower risk of permanent loss. For long-term investors, this is likely to be a far more pressing concern – even amid today’s rising stock market and buoyant economy.
