My friend STE took some time out to write his reflective piece about volatility and risk. You can read a misconception about investing risk and market volatility.

STE explains that volatility is short-term panics that disrupt you from building long-term wealth, but it’s not risk. He cited how great investors like Buffett, Peter Lynch and Howard Marks look at the volatility and risk opinion.

I came from the school of understanding that risk is a permanent loss of capital, and volatility does not equal risk.

But as I age and see more of the market, I can understand why volatility is risky.

You will look at volatility differently from risk depending if you are referring to a basket of securities or an individual security.

Let me try and explain.

My training as a systems safety engineer has led me to understand that risk is a deviation from the intended path.

But what is the “intended path”?

If we are discussing an Individual Security

There is a real risk that individual security will not appreciate based on its intended path ( which is up or down based on your assessment). For example, you assess that Boeing trades at $148 today but its intrinsic value if you stay invested 20 years from now is closer to $450.

Based on the baseline of how well individual companies tend to survive, most companies don’t really survive in the long run, and only a minor number do survive individually.

There is a real risk of a company like Boeing going bust. That uncertainty creates an opportunity for a potential return.

The market constantly reprices a security based on new information. So, if there is a big volatility downturn, the market doesn’t believe the stock will do well or even survive longer than it should.

You might treat this as volatility if you have a different opinion from Mr. Market, and you might treat it as risk if your opinions are similar.

How sure are you that your analysis is better than the aggregate analysis of the cohort of investors? How sure are you that your analysis even matters?

The significant disagreement that becomes more as noise is the disagreement over earnings growth over which time frame. I find that the market tends to extrapolate this quarter’s guidance forever. This is usually incorrect, and therein lies the opportunity to benefit.

For example, the market is expecting that the earnings growth guidance provided by Boeing in the last quarter financial announcement is going to be forever, and price the stock as it should.

You will disagree that the poor earnings growth is that long and there would be a turnaround.

While the market tends to be efficient generally I do find there are opportunities here. The market is very efficient to downgrade a stock like Fortinet down drastically if the guidance is poor.

However, if you assess correctly that the market is pricing in this poor earnings growth over too long of a timeframe and earnings growth should pick up, there is an opportunity there.

If we are discussing a Basket of Securities

As a basket of securities, the risk is still a deviation from the intended path, which can be up or down, depending on how you look at it.

History shows that, as a basket, the expected returns tend to be positive in the long term.

So up is the intended path.

The risk is if it doesn’t go that way. As a basket of securities, this is harder. We can debate that the long term growth rate is 1%, 3% or 10% p.a.

The beauty of diversification is that:

1. You mitigate the risk that your poor choice permanently impair your capital (this is the risk most of us feared)
2. Proper portfolio construction allows the portfolio to rejuvenate where poor choices become smaller and better investments becomes a more significant part of the portfolio.

In this way volatility does not equal risk.

However if you expect the return to be close to 10% p.a. after 15 years of investing but you achieved 13% or 7% p.a., that is deviation from YOUR INTENDED expectation.

That is a risk if you frame it that way.

Had you know that the investment only makes 7% p.a., you would have put your money in something that earns more than that with perhaps lower volatility.

This deviation of long term return is a real risk especially because we are planning for our financial goals.

Imagine you expect this portfolio of stocks to do 12% p.a. You will allocate a starting and recurring capital based on that assumption. However, 15 years later, the market actually did only 5% p.a. I consider 5% p.a. to be decent but that is not enough for a very important financial goal of yours.

So how can we say this volatility is not risk?

Conclusion – How do You Make Use of My Reflection Today

I feel that volatility and risk is more join than they are different.

More importantly, if you agree with me here are some handles:

1. Be more aware which strategy you are running and how volatility and risk should be view in that strategy.
2. If you are looking upon risk and volatility in an individual stock perspective, volatility == real risk for the company if the market is right that this company’s future is going to be very poor. There is a risk of permanent impairment of your capital.
3. There is an opportunity to profit if you discover you have a consistent edge to correctly disagreeing with Mr Market most of the time regarding the timeframe of earnings growth and expectations.
4. If you are investing in a portfolio of stocks, the chances of a permanent impairment of capital is lesser. Volatility is not equal to that kind of permanent impairment of capital risk most of the time!
5. However, you need to be aware that risk is expect X% p.a. and only getting Y% p.a. 15 years down the road. There are real financial implications and we cannot say that this is not a risk.

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