What exactly is risk and what does it mean to investors? To all of us familiar to Buffet’s writings, he has made numerous references on this point. While I think there has been a tendency to over analyze his comments, I do think this is a very important discussion when it comes to an investment process of your own.
Given the market’s recent chaotic behavior, it seems very appropriate to raise the discussion about concepts of volatility. Let’s first understand the text book definition of volatility. The investment community defines volatility as the standard deviation of returns or variance of returns. In simple terms, the standard deviation is the degree of variance around average returns over a given time period. It is a quantitative attempt to measure an investment’s risk. If an investment yields a 10% return for the year yet swings from a 5% loss to 20% gain over the course of the time period, it may be considered volatile. In contrast an investment that grows steadily over the year (i.e. treasuries) will have much lower volatility, thus lower standard deviation and lower risk. At least that’s the academic view point. In the investment community volatility equals risk and, at least in theory, risk is bad if high relative to returns. Following this line of reasoning, if a highly volatile equity fund returned 5% annually and a CD also returned 5%, clearly the fund would exhibit a much different risk profile. Thus the return relative to risk is much less favorable compared to the fixed income investment. This is an exaggerated example, but it gets the point across. Standard deviation is considered to be the primary statistical way to measure risk.
I (like Buffet) believe this definition is flawed for many reasons. I completely understand that a high degree of price fluctuation may seem risky. At the heart of this discussion lies the difference between risk and uncertainty. Often these two ideas are used interchangeably, and it’s easy to see why. Something that is uncertain seems very risky and vice versa. However, this is usually not the case.
While indeed unsettling, uncertainty usually creates unique opportunities. In fact, the best risk / reward payoff may arise in periods of extreme uncertainty (such as the current environment). O.K., so if risk may not necessarily be defined as volatility – how do we determine risk? The most successful investors of our time think of all potential investment opportunities as the relationship between potential payoff and loss of capital. Investments are made only when the probability of positive return expectation greatly exceeds that of a loss (think intrinsic value). Ironically, it is in times of extreme volatility that these positive return expectations present themselves. When the reward / risk relationship is most attractive, the actual risk may be the lowest. As you can see, the uncertainty caused volatility which is not necessarily a negative thing. This is when the bet is made – when the odds are most in their favor. This is not necessarily risky; and it’s the only way to achieve superior long-term results.
Why do we as human beings equate volatility and risk? Perhaps it’s because we have a linear perception of reality. Our minds are only capable of digesting events in an ordered way. However, the world doesn’t always work in that fashion. Reality is much more likely to play out in logarithmic events. These are the unexpected shocks to the system. The outlier events on the normal distribution curve. As discussed in previous articles, these events happen with some regularity, yet our linear minds are unable accept them with any comfort. Our minds are simply not hardwired that way.
