Howard Marks, chairman of Oaktree Capital Management, one of the world’s largest distressed-debt investors, has often argued against the purported identity between volatility and risk.
In conversation with Morningstar, he explains that there are various risks: the probability of losing money, risk of falling short of your goals or needs, the risk of being forced to sell on a downward fluctuation, or the risk of an investment being unable to recover for fundamental reasons. But volatility and risk cannot be used interchangeably or as synonyms for each other.
In one of his memos which appeared on Morningstar.com, he explained that he did not think investors fear volatility. A downward fluctuation – which by definition is temporary – does not present a big problem if the investor is able to hold on and come out the other side. What investors do fear is the possibility of permanent loss. Because one can ride out volatility, but one can never get a chance to undo a permanent loss. Permanent loss is very different from volatility or fluctuation.
It is more helpful to think of volatility as sudden price movements. Volatility encompasses the changes in the price of a security, a portfolio, or a market segment both on the upside and down. So it’s possible to have an investment with a lot of volatility that is moving one way: up (not always down).
Even more important, volatility refers to price fluctuations in a security, portfolio, or market segment during a fairly short time period—a day, a few weeks, a month, even a year. Such fluctuations are inevitable and come with the territory. If you are in for the long haul, volatility is not a problem and can even be your friend, enabling you to buy more of a security when it’s at a low ebb.
When stock prices go low, the market actually becomes safer. In 2008, the global crisis drove securities prices to especially low levels actually making them less risky investments. Indeed, Seth Klarman, one of the world’s most respected value investors, believes that risk is not inherent in an investment, it is always relative to the price paid. So in the midst of volatility and extreme uncertainty of 2008, the risk of investing in equity actually dropped.
This is the reason Marks believes that risk does not actually lie within the components of the market; it's the people who are interacting with that market. The risk is not in the stock certificate. It's not in the stock exchange. Most companies are much steadier than their stocks are. The risk is in the behaviour of the investors. And if investors are panicking and dumping their securities, then the market becomes safer. If investors are buoyant and overconfident, that's dangerous and we should recognise that.
Reactions to volatility are very often emotional. Investors buy and sell on reaction, or rather overreaction, to news and speculation without any significant consideration to long-term returns. Recall the sell-off of not just 2008 but even 2011 when volatility went through the roof. Now look at where the market is today. The volatility did not really affect the long-term returns of an investor who assesses risk in terms of long-term failure to meet a pre-determined outcome. Those who ignored the volatility and stayed are better off because of it.
There is no free lunch in investing; if you're going to invest in the markets, you're going to be exposed to the markets--up or down. What you can come to terms with is the fact that volatility is inevitable and if you have a long enough time horizon, you will be able to harness it for your own benefit.
Once you make your peace with volatility, you can assess the risk of the investment and your comfort level with it.
Here are some takeaways for your portfolio:
- Do not eliminate equity from your portfolio citing volatility. If you do so, you run the risk of not meeting your goals. Think about it. Any investor who parks too much money in fixed-income assets faces other types of risk such as inflation risk and shortfall risk. Shortfall risk is the risk that an investment’s actual return will be less than the expected return, or more accurately, the return needed to meet one’s investment goals.
- Because the terms risk and volatility have become conflated, investors fail to look deeply into the meanings of each. As Marks says, “people say I’m going to invest in an index fund and get rid of risk. The risk they get rid of is the risk of underperforming. The price of giving up the risk of underperforming is giving up the risk of over-performing.”
- The stock market will always go through bear phases, and probably extreme ones at that. It will also have periods of gut-wrenching volatility. That does not mean investors should bypass any investment in the stock market altogether. Instead, they should be aware of the potential for short term volatility to affect the value of their investments and plan accordingly.
- During volatile phases, stay the course. If you are convinced of your investment thesis – be it a stock or a mutual fund, there is no need for you to exit.
