Tuesday, May 11, 2010

Volatility Sources

The mainstream finance industry equates price volatility with risk and believes the market to be efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risk (i.e. buying stocks with higher volatilities).

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!


Anonymous said...

This article coincides with a chapter I just finished in David Dreman’s book Contrarian Investment Strategies - The Next Generation. Chap 14. What is Risk? Dreman writes about those professors in the 70’s that tried to correlate volatility with risk. Surprisingly this is how most people still think. Those same professors 20 years later in the early 90’s proved that their theories were in fact in-correct.

The chapter goes on to define what is real risk, which is investing in fixed income securities such as t-bill, bonds, savings accounts and insurance…why because of the 2 headed horsemen (defined in chap 13) of inflation and taxes. Those two have eaten fixed income investments alive since after WWII when inflation and high taxes have become the norm in the U.S. and other similar countries.

I highly recommend this book to all readers of this blog. Though I believe Dreman doesn’t write anything new as far as value investments this book does provide a more current view of the world as compared to Graham’s day. Some pieces of the book are a bit out of date, such as don’t buy small stock that trade on Nasdaq, but overall the book is good.

Saj, maybe you could do a book review and provide better summaries?


Saj Karsan said...

Hi Justin,

Yeah that book is on my reading list. In the meantime, we have written about Dreman's 1982 book with a similar title here.