Bill Sterling is Global Strategist for C.I. Global Advisors LLP, who are one of the fund managers for C.I. Mutual Funds. His reports are interesting and timely, especially for anyone interested in the larger global picture and how it may affect their investments. See our links page for links to C.I. Mutual Funds and other featured mutual funds.
His recent book, "Boomernomics", is highly recommended.

Does Risk = Volatility?
 

by Bill Sterling  (March 2001)

Investors are becoming increasingly focused on coping with market volatility and portfolio risk as global equity markets remain under pressure. We continue to believe that aggressive Fed easing is likely to mark an end to broad market weakness before too long. In the meantime, we are squirming with discomfort - along with most other investors - as the market's form of Chinese water torture persists.

Since investing is all about balancing risk and return, we thought it would be useful to review a few concepts that will put the current bout of volatility into perspective. And tough as it is emotionally, the conclusion for investors who have a sensible asset allocation and well-diversified portfolio is, to borrow Ronald Reagan's line, "Don't just do something, stand there."

Most investors identify risk with market volatility - and for good reason. If you need your money back in a few weeks to pay your bills, it obviously doesn't make sense to put it in the stock market. Ditto for money earmarked for expected expenses over the next year or so, like college tuition payments. As J.P. Morgan observed years ago, the only thing certain about the stock market is that "it will fluctuate."

The Manic-depressive Mr. Market

An entire industry has now been built on measuring financial risk in terms of volatility. Accordingly, many financial planners and consultants are now fully armed with a slew of statistics ranging from plain vanilla measures like standard deviations to more esoteric measures like information ratios and semi-variance (don't ask). For the most part, the introduction of these measures has been extremely healthy for the financial services industry because it has forced fund managers to remain mindful of risk issues amid the never-ending competition to generate good returns.

Having said that, the conventional view that Risk = Volatility has come under some intense criticism as well. No less an authority than Warren Buffett has argued that "the academics' definition of risk is far off the mark, so much so that it produces absurdities." As an example, he noted that volatility-based measures of risk would suggest that a stock that had dropped a lot in price is "riskier" than it was at a higher price. Puzzled, Buffet believes that true investors should welcome volatility because it occasionally provides investors an opportunity to pick up assets at low prices.

According to the sage of Omaha, "the real risk an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake." In other words, will you eventually end up with more money than you could have had by keeping your money in a bank or government bond?

Chart 1. Which is riskier? Stock A, whose price fluctuates widely but rises over time? Or Stock B, whose price moves down but with very little fluctuation?

 In the spirit of "one picture is worth a thousand words," consider Stocks A and B on Chart 1. Stock A fluctuates a lot, but also trends up over time. Stock B fluctuates very little but trends down. A volatility-based measure would deem Stock A to be very risky and Stock B to be less risky. But according to Buffett's definition, Stock B is clearly riskier from the point of view of a long-term investor. Stock A also has the attraction of occasionally going "on sale," creating attractive entry points for long-term investors willing to ride out the subsequent ups and downs.

Further complications arise from the fact that past volatility - which you can measure easily - does not necessarily predict future volatility with any precision. In other words, it is perfectly possible that Stock B could meander along a flat line for a long period of time, with little volatility, and then break out in a major way to the upside or the downside. Understanding the fundamentals of the company or the industry in order to get a sense of whether a company has a sustainable competitive advantage and reasonable valuation may be a far better form of risk control than focusing too much on past price behaviour of the stock.

To be sure, high volatility can be disturbing and painful, especially when it causes investors to sell in a panic. Unfortunately, the urge to panic seems hardwired into human nature, so much so that legendary investment analyst Ben Graham once described "Mr. Market" as a manic-depressive who is sometimes willing to attach irrationally low prices to fundamentally solid companies. Fighting the urge to panic is the hallmark of a good investor. In that regard, we are fans of one of financial writer Nick Murray's favourite lines: "No panic, no sell. No sell, no lose."

Why Your Investment Horizon Matters So Much

Another powerful perspective on investment risk is to consider how different types of investments have performed over different time periods - and why the long investment horizons of those saving for retirement matters so much.

Chart 2. News flash: Stock prices of risky C and D companies have been nearly twice as volatile as those of A-rated blue chips. But high risks have been rewarded with high returns.

 Chart 2 shows how different types of stock groups have performed over all five-year periods from 1986 to 2000 (using rolling monthly data). The charts are based on a report from Merrill Lynch's Quantitative Strategy team. The stock groups are based on Standard & Poor's Common Stock rankings, which rank companies based on their stability in earnings and dividends growth over the past 10 years. Companies with extremely stable earnings and dividends growth are rated A+, while the riskiest companies are rated D.

Not surprisingly, the C and D-rated companies have had much more volatile stocks over long periods, as reflected in their position on the far right of the graph (high standard deviation of returns). But they have also had higher returns on average, since investors have tended to demand some compensation for coping with the riskier situations. The only notable anomaly seems to be that A+ companies have had somewhat higher risk and return than A, A-, and B+ companies.

Now for the surprise. What if, instead of defining risk as volatility, we define risk as whether you lose money over the entire investment period? That's a fairly common-sense approximation of how many people think about risk.

Chart 3. From 1986 to 2000, there were no five-year periods when investors lost money in risky C and D-rated companies. And investors were richly rewarded for tolerating volatility.

 Chart 3 shows the average five-year return of different types of stocks versus the percent of five-year periods that experienced negative returns. Interestingly, over the 1986-2000 period, none of the stock groups experienced negative returns over any random five-year period. Not one. So for long-term investors, the risk of losing any money turned out to be extremely low.

A caveat: this was an exceptionally good period for equity markets, so the results cannot be naively extrapolated to the future.

Given the fact that all of the stock groups had similar risk - by our new definition - what is notable in this exercise is how much higher the returns were for "risky" companies like the C's and D's (140% plus), compared to "safe" companies like the A's and B's (70% to 75%). With the benefit of hindsight, it turns out that the safe A's and B's were less impressive investments, even accounting for the risk of whether or not you get your money back.

Obviously, the analysis changes a bit if you look at different time periods. But surprisingly, even for periods as short as three years, A-rated companies lost money less than 2% of the time, while C and D companies lost money only 6% of the time. But the return of the high-quality companies was again roughly half of the 70% average three-year return of the lower-quality companies.

The historical evidence is clear: time is the investor's best friend. As long as the basic trend in the economy and in equity markets is up, investors who ride out the volatility tend to make money. And given the impressive returns generated by "risky" companies, investors have benefited from having at least some portion of their portfolios invested in non-blue-chip companies like the C and D companies.

Yes, the equity markets have been volatile. Yes, there is talk of recession in the air. But valuations have become far more reasonable, the Fed is now easing, and a recovery will probably be underway in the second half of the year. From that perspective, markets are arguably far less risky now, when investors feel despondent, than they were a year ago, when investors felt euphoric.

One more time: No panic, no sell. No sell, no lose.

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