Gustavo Ballvé on September 14th, 2011
Food for thought, Home, Investment Themes, Mental models, Portfolio Management, Risk management, Signal or Noise

Many dimensions to this Sept. 3rd Op-Ed by Robert Shiller in the NY Times about “the surge in stock market volatility” in August. A few days later, on Sept. 11th, another NYT article argued – in the title, no less – that “market swings are becoming new standard”. The first question to ask is whether the short-term reality of higher volatility isn’t simply being taken for granted and extrapolated into the future, but the second question runs deeper: would it really be so bad for long-term value investors?

On the first question, we’ve posted on this in Feb. 2010: It’s well know that there is an ever-present and history-defying trend to extrapolate the current situation into the future (and future in this case means 2-5 years ahead). To ignore cycles having so much historical data available is amazing. If everyone believes the market will remain this volatile forever, that’s precisely when it starts to soften up.

But there’s another flaw, and that is one in which “visibility” is confused with “low volatility”. Investors believe that “visibility” is “good” when things are calm and that it’s somehow “cloudy” when volatility rises. It’s like saying the 2004-2007 period was “high visibility” and yet the year ended as it did, and 2008 was what it was. In that same theory, a “high visibility” period began anew sometime during 2009… When one looks at Brazil in 2009 with its spectacular rise from the crisis’ lows, the market had to have been riskier after the rise than before it, yet some saw the precisely inverse relationship. Those who were cautious built the “cash as strategic weapon/ both cushion and cannon” stake and were ready to take advantage when things got more agitated.

The second question is obviously more complicated and we’ll just propose the “conversation starters”:

First and foremost, we’d point that volatility shouldn’t be a measure of risk at all. Risk, as we define it, comes from “not knowing what you’re doing” in the many dimensions of investment analysis, be it idea sourcing, networking, research and ultimate execution – what instrument(s), what sizing, what hedges and why etc. It also comes from paying prices that don’t allow for significant margin of safety. Of course, it also comes from not allowing time for the idea to play out – if you need the money back in a month and anything goes modestly south, it will turn from an opportunity to increase your stake into a realized loss. By the way, this last factor is also influenced by the type of customers one “chooses” – those with a happy trigger and weak stomach can cause havoc on a great portfolio that fell just a little bit. Finally, it can also come from leverage. But if one approaches the processes with the required seriousness (and skills, hopefully), increased volatility shouldn’t a problem. See the note about “cushion and cannon” above.

Another point: as we’ve argued before (here and more recently here), in the case of the ages-old search for the “risk-free rate” to power valuation models and calculations, there is always the choice of not making volatility such a relevant factor in your portfolio management approach. It’s useful as a mental model and habit not to worry about short-term volatility. As Buffett has proposed many times, you should be looking for the investment opportunities that you would feel comfortable owning even if the markets closed for 2, 5, 10 years.

Finally, when volatility strikes, don’t panic.

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