- Created on Wednesday, 27 February 2013 00:00
- Published on Wednesday, 27 February 2013 07:00
- Written by Justice Litle, Contributing Editor, Inside Investing Daily
- Hits: 747
Yesterday, stock markets around the world plunged following news that anti-austerity parties had won Italy's election.
U.S. stocks had their biggest loss since November. And Wall Street's "fear gauge," the VIX, shot up 34%.
The VIX tracks the price investors are willing to pay for portfolio insurance in the form of stock options. A high reading (typically above 30) signals expectations for volatility -- big price swings in stock prices -- are high.
This can be scary. Especially if you're long the market when these sharp volatility spikes happen. But despite what Wall Street experts say, volatility and risk are NOT the same thing.
The volatility = risk lie is bolstered on three fronts.
- Academics teach it.
- Salesmen preach it.
- Investors feel it in their gut.
In other words, it's natural to fear volatility. But it's also extremely dangerous to your wealth.
The consensus is that smooth returns are better than volatile ones. But this myth is easily dispelled with two words: Bernie Madoff.
Madoff enticed investors for decades with his smooth and steady returns. Rain or shine, Madoff's investors made money. They loved him for it. Until the whole thing went kablooey.
Conmen deliver smooth returns because that's what investors crave. The same thing happens with bad investment strategies.
Take Ralph Cioffi and Matthew Tannin. These two gents ran a subprime credit hedge fund for Bear Stearns in the glory days of the housing bubble.
Cioffi and Tannin were not crooks. They just weren't very bright. For a long time, their subprime fund delivered wonderfully smooth returns. They delivered 1% returns each month for more than 40 months in a row. Investors adored them. Then the subprime bubble burst; the funds imploded; and investors lost $1.6 billion in 2007.
The trouble with low volatility strategies is they are not natural. The real world is messy. It is lumpy. It is volatile.
In the real world, business profits are volatile. One month you make a lot of money. The next month you make less. Then you may make no money at all. And then you enter profit again. Why should it be any different for stocks?
More important, volatility is not always bad. In fact, a lot of the time it spells opportunity.
Consider the chaos surrounding the March 2009 lows. That was an incredibly attractive entry point, with many stocks compressed to ridiculously low valuations (in some cases less than net cash in the bank) due to forced selling.
To exploit those kinds of opportunities, you have to make volatility your ally.
Warren Buffett, and his mentor Ben Graham before him, offers an alternative view of what "risk" is. According to these two, risk should be viewed as the prospect of permanent capital loss -- not a measure of how volatile something is.
Think about how much sense this makes.
If an excellent company -- like, say, Wal-Mart or Coca-Cola -- is trading at extreme fire-sale prices because Mr. Market has panicked, the volatility of the share price will not impede these companies' ability to keep making money, quarter after quarter, for decades to come.
As Buffett puts it, if a dollar bill is trading for 50 cents, and then goes to 40 cents, the risk of buying it as an investment has gone down, not up.
So, next time market volatility spikes up, don't panic. Instead, use it to buy quality assets selling at "fire sale" prices.
Think like a business owner when it comes to making your investments. When buying shares in a company, the relevant question is how much is it worth relative to the share price -- not how wildly share prices are swinging up and down.
The Next "Flash Crash" Could Happen Tomorrow...
Computers have taken over the stock market. One of every two trades is done automatically by a computer.
These "high-frequency traders" -- as they're called -- caused a 9% loss in five minutes during the "Flash Crash" of May 6, 2010. And they've only gotten more powerful since.
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