Volatility Is Not Risk

I was recently invited to speak at an investor conference on the subject: “How to find performing investments in a period of unstable markets?” Although this was a convenient introduction to Tocqueville’s long-standing argument in favor of contrarian value investing, it occurred to me that the question itself was perversely misleading.

Presumably, during the 1990s, most investors had come to view a stable market as one that rises steadily. But for anybody with some historical perspective, this is obviously an oxymoron. Almost by definition, it would be very hard to find performing investments in a stable market, e.g. one in which stocks don’t go down or up very much.

The above example and many others, which are reflected in the proliferation of advertisements for “riskless” investments, illustrate the degree to which investors, lured by savvy marketing types, have become obsessed with risk avoidance.

In part, this constitutes a return to normal investor behavior. Many psychological studies have documented investors’ aversion to risk, and their natural tendency to put a high (often irrational) premium on investments that they perceive as lower-risk ones.

The problem, however, is that investors as a group do not assess risk very well. For example, during occasional periods of “irrational exuberance”, they often put insane price premiums on some investments perceived to have low fundamental risk, to the point where it is the price premium itself that actually becomes the risk. This is what happened in the late 1990s stock market bubble, and the reverse typically happens after long market declines.

In addition, investors tend to measure risk in the same way that they evaluate weather forecasts. An eighty percent chance of rain means that it is likely to rain. But there is a measurement risk: how do we know it’s not ninety or seventy percent? Also, your risk depends on both the severity of that rain and on what you have to lose by getting wet. Furthermore, that risk may be acceptable, depending on what you have to gain by going out anyway. And then, of course, there’s always that twenty percent chance that it will not rain…

Warren Buffet is fond of saying something to the effect that “time is the investor’s friend and the speculator’s foe”. In other words, many market participants tend to confuse risk and volatility. For long-term investors, volatility merely represents background noise: not a true risk, but an annoyance. This is illustrated in the following graph, which depicts the fifty-two-year performance of the Dow Jones Industrial Average against the year-to-year percentage changes in that same index. As can readily be seen, the long-term investor would have done quite well with little absolute risk, while the short-term trader could easily have become financially seasick.

Of course, time is of the essence. This is true for companies, which can be technically solvent but so illiquid as to be threatened by default. At most times, it is solvency that counts (more assets than liabilities). But if credit becomes unusually scarce and expensive, illiquid companies can become crippled by the lack of ready-cash. Similarly for investors, volatility only becomes a problem when they urgently need to sell: the rest of the time, it’s just a phase.

Finally, volatility is not inherently bad. If you are convinced you are near a market bottom, you should wish for maximum volatility, rather than “stability”. For contrarian value investors, I would even argue that it is volatility that creates opportunity.

Mistaking risk and volatility can be dangerous. In their current frenzy to avoid volatility, investors are willing to look at anything that promises to lessen it. In doing so, they overlook perennial questions that should be asked of any investment – such as, for example: “How does the seller make his money?”

Guaranteed-principal products, which have become popular, typically guarantee your initial investment while allowing you to participate in market gains. No risk, some gain. To achieve this goal while minimizing their own risk, institutions that sell these products engage into sometimes-complex hedging strategies involving the purchase of options, futures contracts, etc. These operations cost money, of course: not only to execute transactions, but also because counterparts in these transactions incur a risk, which needs to be remunerated as well. Paying for these costs, as well as for the “manufacturing” and selling of these products (not forgetting a reasonable profit), shaves the buyer’s promised “participation” to capital gains by a substantial margin.

Remember that, over the very long term, stock market returns have only been in the 9% range and that, after the abnormally high returns of the 1990s, they are more than likely to yield less in the coming decade. Add in a likely acceleration of inflation, which will further reduce “real” returns, and there will be little gain left for the purchasers of the products.

Another type of product that has gained extraordinary popularity in the last few years is “hedge funds”. In this case, there is little doubt as to how the seller makes his money: hefty management fees plus an equally hefty share of the returns. These charges have recently been aggravated, in many cases, by the superimposition of similar fees by asset allocators and “funds of funds”. These new channels make previously exclusive hedge funds accessible to smaller investors, which would usually be enough of a warning to stay away.

In addition, it is somewhat ironic that these new “supermarket” instruments claim to reduce the volatility of returns by diversifying among several hedge funds, since hedge funds themselves claim to reduce volatility through the use of short selling and derivatives strategies. Volatility may indeed be reduced. But, with so much more money now chasing relatively few opportunities and the number of hedge fund managers having grown well beyond any definition of an “elite” group, it is a fair bet that superior returns of the past (generally achieved on much smaller portfolios) will not be matched in the coming decade. In other words, the hefty fees charged by manager and “managers of managers” will bite heavily into returns to investors.

Another worry is that most hedge-fund managers claim to use “black-box” techniques to achieve their promised results. This means that investors are buying into something they are not meant to understand. Even with the most sophisticated managers, these black boxes usually have a fly in the ointment, as the fiasco of Long Term Capital Management and a growing list of others since have shown. But it is the curse of both greedy and timorous investors to believe most ardently in what they can’t understand.

More generally, the current, pseudo-conservative rush into riskless investments has a very fundamental flaw. Private enterprise is the main source of wealth creation in modern economies. Everything else amounts to pie sharing: it is desirable, even necessary, but if carried to excess, it becomes a source of national impoverishment. Bourses (such as stock exchanges) are merely a bridge between entrepreneurs and non-entrepreneurs. Entrepreneurs are allowed more and cheaper opportunities to finance their businesses, and savers are allowed a means to participate in the nation’s wealth creation, which originates in the private business sector.

All derivative gimmicks, mathematics-based and others, which have become so popular in recent years, are drawing the investment process farther and farther away from this essential function. In the process, they may reduce volatility, but they also are loosing sight of the essential goal of investing: to earn returns superior, over time, to those on mere savings accounts. And superior returns come with the assumption of reasonable business risks.

A private business owner knows the value of his or her enterprise, but does not need the stress of seeing its price posted daily in the newspapers. Investors would benefit hugely from doing the same: ignoring the short-term volatility of their investments, they would be able to concentrate on the fundamental values they own, as well as the true risks they are assuming or avoiding.

François Sicart

April 14, 2003
^©Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.